Chapter 2: FCF

Operating vs Non-operating current assets and long-term assets

• Operating Assets 

  • Operating CA 

    • Current assets used to support operations 

    • Cash, AR, INV 

  • Operating long-term assets 

    • PPE (net of depr) 

• Nonoperating- include investments in marketable securities and non-controlling interest in the stock of other companies 

  • Rule of thumb: if an asset pays interest, it should not be classified as an operating asset 

Operating vs Non-operating current liabilities

• Operating current liabilities are short-term liabilities arising from a company's day-to-day operations. They represent funds the company temporarily holds and can use to finance assets. 

  • Accounts Payable

  • Accrued Wages 

  • Accrued Taxes 

  • Other Accrued Expenses 

• Investors - are investors non operating current liabilities????

• Rule of thumb: if a liability charges interest, it is not an operating liability 

• Each dollar of operating current liabilities is a dollar that the company does not have to raise from investors to conduct its short-term operating activities 

Net operating working capital

•  NOWC is a measure of a company's short-term liquidity and its ability to manage day-to-day operations. 

• NOWC is the net operating working capital is the working capital acquired with investor-supplied funds. 

• NOWC= operating CA - operating CL

• NOWC= (cash+ AR+ inventories) - (AP + Accruals) 

• Working capital acquired with investor-supplied funds- This means that part of the company’s liquidity (cash, working capital) could come from issuing shares or other equity investments — but that wouldn’t directly count as part of NOWC since NOWC measures assets and liabilities tied to operations, not financing.

• A positive NOWC means the company has enough current assets to cover its short-term liabilities, indicating financial health.

• A negative NOWC might suggest liquidity problems or over-reliance on short-term liabilities.

Total net operating capital

• TNOC is a broader measure of the capital a company uses to run its operations.

• TNOC= NOWC + operating long-term assets 

• Net Operating Working Capital (NOWC) – Represents the short-term capital used in operations (current assets minus current liabilities).

• Operating Long-Term Assets – Includes long-term assets that are necessary for business operations

• TNOC reflects the total amount of capital tied up in both short-term and long-term operational assets.

• It’s a more complete measure than NOWC because it accounts for both current and long-term capital needs.

• A higher TNOC suggests that a company is more capital-intensive, meaning it requires more funds to sustain its operations.

• NOWC = Short-term operational capital

• TNOC = Total operational capital (short-term + long-term)

Net Operating Profit After Tax (NOPAT)

• NOPAT – Focuses solely on operational performance, removing the impact of financing decisions to reflect how profitable the core business is.

• NOPAT helps compare companies with different capital structures because it isolates operating performance from financing strategy.

• NOPAT= EBIT (1-Tax Rate) 

• (1 - Tax Rate) = Adjusts EBIT for taxes but excludes the impact of interest expenses

Free cash flow

• FCF is a key financial metric that measures the cash a company generates after covering its operating expenses and capital expenditures (CapEx).

• FCF is the cash flow available to investors after investments in fixed assets and investments in working capital 

• Fixed assets – Capital expenditures (CapEx) like purchasing property, equipment, or technology.

• Working capital – The day-to-day operating needs of the business (like inventory and accounts receivable).

  • FCF shows how much cash is left over after running and maintaining the business — this is what the company can use to create value for shareholders and creditors

• Uses of FCF- 

  • Interest to debt holders 

  • Repay debt 

  • Dividends to shareholders 

  • Repurchase shares 

  • Marketable securities or other non-operating assets

  • Value of a firm depends on future FCF (firm value increases as FCF increases) 

  • FCF= NOPAT - Net investment in operating capital

Return on Invested Capital (ROIC)

• ROIC is a key profitability ratio that measures how efficiently a company uses its capital to generate profit.

• ROIC- net operating profit after taxes divided by total net operating capital. Provides a measure of how well the company is operating because it excludes the impact of financial leverage. 

• ROIC = (NOPAT/ Total Net Operating Capital) 

• ROIC measures how much profit a company generates for each dollar of capital invested in operations

• Measure how much NOPAT is generated by the firm’s total net operating capital 

• ROIC > WACC: the firm is adding value 

• It’s a way to assess whether the company’s growth is profitable.

• A high ROIC means the company uses its capital efficiently to generate returns.

• A low ROIC could indicate that the company is not earning enough profit relative to its capital use.

Market Value Added

• MVA is a measure of how much value a company has created (or destroyed) for its investors

• MVA- the difference between the market value of the firms (that is, the sum of the market value of common equity, the market value of debt, and the market value of preferred stock) and the book value of the firm's common equity, debt, and preferred stock. If the book values of debt and preferred stock are equal to their market values, then MVA is also equal to the difference between the market value of equity and the amount of equity and equity capital that investors supplied. 

• MVA = market value of firm - BV of firm 

• MVA reflects the difference between what the market believes the firm is worth and its worth on paper.

• MVA measures a company’s ability to generate value beyond the cost of its capital.

• High MVA suggests strong market confidence in the company’s future performance and growth potential.

• Low or negative MVA could signal that the market views the company’s future prospects as weak or uncertain.

• If MV of debt= BV of debt and the company has no preferred stock, then 

  • MVA= MV of common equity- BV of equity 

Economic Value Added

• EVA is a measure of a company's financial performance that reflects how effectively management is creating value

• EVA- a method used to measure a firm's true profitability. EVA is found by taking the firm's after-tax operating profit and subtracting the annual cost of all the capital a firm uses. If the firm generates a positive EVA, its management creates value for its shareholders. If the EVA is negative, management has destroyed shareholder value. 

• EVA = NOPAT - AFter-tax dollar cost of capital used to support operations 

• EVA= NOPAT - (total net operating capital)(WACC)

• EVA= (total net operating capital)(ROIC- WACC) 

• EVA measures how much value a company creates (or destroys) after covering the cost of capital.

• If a company earns more from its capital (ROIC) than it costs to finance that capital (WACC), it creates value.

• If ROIC is less than WACC, the company is destroying value because the return on capital isn’t high enough to justify the cost.

• Positive EVA → The company is generating value for investors.

• Negative EVA → The company is not generating enough returns to cover the cost of capital.

• If a company has a history of negative EVAs, its MVA will probably be negative; conversely, if the company has a history of positive EVAs, its MVA will probably be positive.

• EVA shows the value added during a given year, whereas MVA reflects performance over the company's entire life.