Aspects To Consider in a Cash Flow Analysis

In many transactions, the free cash flow is THE starting point for any modelling purposes, for example, the discounted cash flow model.

A proper cash flow analysis is important. It ensures a “safe starting point”.

Typically, the free cash flow calculation is as follows:

EBITDA

+ change in net working capital

= Operating cash flow

+ Capex

= Free cash flow

+ Other items (interest expenses, net debt items)

= Net cash flow

The net cash flow must equal the change in the company’s cash position. Otherwise, it is not consistent with the balance sheet.

In a due diligence, several aspects are important when it comes to analyzing cash flow.

What’s the company’s cash conversion rate??This rate indicates a firm’s ability to convert earnings into cash. The calculation is “free cash flow / EBITDA”.

What drives cash flow? Drivers could include EBITDA, working capital, or less capital expenditure. If it’s the latter, is it sustainable or are investments deferred? A reduction in investments can improve the cash position. But is not sustainable in the long run: how will the company generate future revenues?

Is there any cash flow seasonality? If the company shows a strong revenue seasonality, it might also show a cash flow seasonality. This seasonality might reflect a production phase (negative cash flows due to the high working capital) and a period in which revenues are generated. This pattern can show that the company needs intra-year financing. Take a Christmas market operator. Sales will be during Christmas, but goods need to be purchased before, employees need to receive a salary, rent needs to be paid, etc.

Which starting point? Commonly, two options exist: cash flow can either be reported or adjusted. If it’s reported, the starting point is the reported EBITDA. If it’s adjusted EBITDA, you need to reverse these adjustments in the corresponding balance sheet positions.

Include or exclude taxes??Calculate free cash flow before and after taxes to quantify the impact of tax payments.

Include or exclude growth capex? Calculate free cash flow before and after growth capex to illustrate the impact.

Final thoughts

Understanding cash flows means understanding the income statement and the balance sheet. These two statements are reflected in the cash flow statement.

Hi, I am Jan, I share insights about financial due diligence procedures. If you find this helpful and would love to receive more content like this, follow me here on LinkedIn.

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