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Factors that affect the Free Cash Flows of a company
The Free Cash Flow of a company depends on the following factors −
- Sales Projection
- Expense Estimation
- Depreciation
- Capital Expenditure
- Changes in Net Working Capital
- Interest Expenses
- Tax Rates
- Inflation
Let us discuss each of these factors in detail and see how they affect the Free Cash Flows of a company.
Sales Projection
To determine the Free Cash Flow of a company, the first step is to determine its projected sales.
Sales depend upon many factors, such as market share, growth, and demand of products in the market.
A company cannot remain at one stage in terms of sales. There are normal, super-normal, and declining growth phases of a company.
An analyst dealing with the company should determine the stage and thereby project the sales.
Expense Estimation
A company must estimate the expenses beforehand to calculate its Free Cash Flows.
The expenses are majorly divided into two categories - the cost of goods sold and the selling and administrative expenses.
The costs of goods sold has these components - raw materials, wages and power or fuels.
When a company is in control of supply of raw materials, it can have a better bargaining power and vice versa.
By improving labor and machine productivity, the wages can be reduced. The expense in costs can also be reduced by efficient management of the company.
Depreciation
Although depreciation is a non−cash item, it is calculated for determining taxes.
It is determined based on given depreciation rates as categorized and standardized methods.
Depreciation of fixed assets has been prescribed by the governments and companies may follow the list of its category to find the value of depreciation of its assets.
The estimated capital expenditure should be utilized to determine the depreciation of the assets of a firm.
Capital Expenditure
Capital expenditure is a cash outflow that is important for the operational efficiency and sales growth of a company.
Companies need to continuously spend money in capital expenditure to maintain their growth.
However, for constantly evolving firms, the capital expenditure is equal to depreciation of the company.
Changes in Net Working Capital
To determine the Free Cash Flows, analysts should also count the changes in Net Working Capital (NWC) due to the expansion in the sales of a firm. An increase in NWC is an outflow.
Interest Expenses
Interest expenses are not considered in calculating Free Cash Flows. It requires only the value of the firm that represents both debt and equity. WACC is used as the discount rate and so the free flow is not subtracted. It is also assumed that the debt ratio remains constant over the entire period of the project.
Tax Rates
Free Cash Flows are always calculated after tax. Marginal corporate taxes should be used to measure Free Cash Flows.
Inflation
It is expressed in the nominal terms and should be used so. It is a constantly changing term and should be treated continuously in determining the cash flows and the discount rate.
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