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How are equity cash flows calculated?
Equity cash flow is the amount of money a company can return to its investors after paying all the debt it acquired from the market. Also called free cash flows to equity, equity cash flows show the health of a company, as it contains the money that is left after paying all the loans the company has taken from the investors.
How to Calculate Equity Cash Flows?
While there are many formulas to calculate equity cash flows, the most common is the one that uses net income and changes in working capital.
This formula is expressed as −
Free Cash Flow to Equity
= Net Income + Depreciation and Amortization
± Changes in Working Capital − Capital Expenditures
± Net Borrowing
The following steps are used to calculate equity cash flows −
1. Calculate the Net Income
Net income is the amount of money a firm earns after paying all expenses. To calculate the net income, one needs to take the gross profits and then deduct the expenses from it. Net income can also be found in the balance sheets for the previous year.
2. Calculate Depreciation and Amortization
Depreciation and amortizations are the reducing values of assets of a firm. For example, if a firm owns a vehicle, its value will go on decreasing over the period of calculation of its value. This is known as depreciation.
For the given formula above, the value of depreciation and amortization can be found from the income statement of a firm.
3. Calculate the Changes in Working Capital
Working capital measures the company's assets and liabilities. To find the change in working capital over a given period, one can use the formula −
$$\mathrm{Change\:in\:Working\:Capital = Current\:Period\:Working\:Capital − Previous\:Period\:Working\:Capital}$$
The amount of working capital can be found in current and previous balance sheets.
4. Finding the Capital Expenditures
Capital expenditures are the amounts of money firms spend to buy tangible assets, such as building and equipment. To calculate the capital expenditure, the asset section of an income statement can be used. The asset section can be measured as a total or the company can add physical asset expenses to find the total amount of expenditures.
5. Calculation of Net Borrowing
The amount of money borrowed by a company in the current period is known as net borrowing of a company. To get the value of net borrowing, the following formula can be used −
$$\mathrm{ Net\:Borrowing\:=\:Amount\:Borrowed\:−\:Amount\:of\:Principal\:Repaid}$$
The data for calculating net borrowing can be found in the current balance sheet.
6. Calculation of Equity Cash Flows
Having all the factors mentioned above, one can calculate the value of equity cash flows. Some of the factors mentioned may be negative and these can be deducted from the equation to get the final equity cash flow.
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