Public companies are financed through debt and equity capital. Providers of debt capital expect a return in the form of interest payments and they also expect to get the principal amount back at the end of the loan period. Providers of equity capital expect to share the profit of the firm after the debt providers have been paid. In essence, the providers of capital benefit if the firm is profitable. The concept of profit in business is not as straightforward as it is in everyday usage. There are different types of profits. In this post, I will explain the different types of profits and the relationship between profit, cash flow, and firm value.
Typically, a firm reports its profit (loss) in its income statement. The income statement, however, is based on accrual and not cash accounting. This means that the profit in the income statement does not correspond with the firm’s actual cash inflows and outflows during the reporting period. Financial analysts, however, are more interested in free cash flow (the cash remaining after all expenses have been accounted for) from a firm’s operations than in accounting profit. I will describe how cash flow used in financial analysis is computed from information available in financial statements.
Sample income statement
I’ll start with the different profit subtotals in an income statement (a sample statement that I copied from the Internet is given above).
Gross profit is the difference between sales and cost of goods sold. Gross profit margin is calculated by dividing gross profit by sales. A high gross profit margin (say 80%) indicates that the firm has 80 cents per dollar of sales to pay off its operating expenses. All things being equal, a high gross margin indicates cost efficiency and/or pricing power. Firms with strong brands and customer loyalty can charge high prices and are therefore more likely to have high gross profit margins.
Note that gross profit is not a cash flow. Sales are often made on credit. Under accrual accounting, a sale is booked if there is an assurance that the revenue is forthcoming. Thus, the sales figure includes sales that have been booked or that have been shipped, but for which cash payment has not yet been received. Similarly, the cost of goods sold may include materials for which payments have been promised but not yet made.
Gross profit is sales revenue minus direct expenses. Cost of goods sold, which includes the cost of materials and labor, is a direct expense. Costs such as utility and wage expenses, which are incurred for operating the business but are not directly associated with a product or service, are indirect expenses. Operating profit is calculated by deducting indirect expenses from gross profit.
One important indirect expense is depreciation expense. Depreciation is a non-cash expense, which means that it does not represent actual cash flow. Suppose a firm purchases a machine for one million dollars. The firm expects the machine to last for 10 years and uses a straight-line depreciation policy (same amount of depreciation expense allocated each year) and does not expect the machine to have any salvage value (value at end of the useful life of the machine). This firm will record $100,000 in depreciation expense each year ($1,000,000/10) in its income statement. This $100,000, however, does not leave the firm in this reporting year. It is a set amount that the firm expects the machine to essentially lose in worth.
Operating income is an indicator of the health of the company’s main business activity. It does not include interest expense (this is viewed as a financing expense and not as an operating expense). Because operating income is income before interest payments have been deducted, it is relevant to both bondholders and stockholders.
Besides operating income, some firms also have non-operating income and expenses. Net income is derived from taking operating income and adding other income, subtracting interest expense, deducting taxes, and then accounting for any income/loss/gains from discontinued operations and/or extraordinary items. Both the discontinued operations and extraordinary items should be reported net of tax.
Commonly “profit” refers to net income. Because net income is computed by deducting interest and taxes, bondholders and the government do not have residual claims on it; stockholders are the only ones who have a claim on net income. A firm keeps some of its net income to reinvest (retained earnings) and pays out the rest to stockholders as dividends. The total net income divided by the number of shares outstanding yields EPS, or earnings per share. A company might separately report EPS from continuing operations and EPS that also includes discontinued operations and extraordinary items.
Financial analysts use the information from the income statement and balance sheet to compute cash flow and also compute income types other than the three I discussed above. I will now describe the other types of income and the computation of cash flow.
EBIT: earnings before interest and taxes. Sometimes also called PBIT (profit before interest and taxes).
EBIT = revenues – cost of goods sold – operating expenses + non-operating income.
If there is no non-operating income (zero in the equation above) the EBIT and operating income are the same. Because interest and taxes have not been deducted from EBIT, both the government and bondholders (in addition to stockholders) have residual claims on EBIT. Because EBIT does not include interest or taxes, it is a profitability measure that is independent of capital structure and tax rate, two components that are not uniform among firms.
What is the relevance of EBIT (assuming it is equal to operating income)? A company can have a high operating income but a low net income. Because net income is the final measure of profitability (all revenues – all expenses), a low net income may “mistakenly” not reveal strong operations.
EBIAT: earnings before interest after taxes
EBIT includes the claims of the government, bondholders, and shareholders. Financial analysts are often interested in the profits available for bondholders and shareholders. In such contexts, taxes are deducted from EBIT to give EBIAT or earnings before interest after taxes. EBIAT is also referred to as tax-effected EBIT.
Related metrics are NOPAT, or net operating profit after taxes (sometimes referred to as NOPLAT or net operating profit less adjusted taxes). If there is no non-operating income, NOPAT equals EBIAT.
EBITDA: earnings before interest, taxes, depreciation, and amortization
EBIT often includes a significant chunk of non-cash expenses. To compute cash flow from EBIT, non-cash expenses have to be added to EBIT. Adding the prominent non-cash expenses of depreciation and amortization to EBIT gives EBITDA.
The government, bondholders, and stockholders all have residual claims on EBITDA (as with EBIT) because interest and taxes have not been deducted. Because interest is not included, EBITDA indicates a company’s capacity to service its debt. In businesses with high fixed costs (ex: airline industry) that have sizeable depreciation expenses, EBITDA is a useful metric. High depreciation expenses can result in a low or even negative EBIT. In such cases, EBITDA is a better indicator of earnings than EBIT. EBITDA is also useful for comparing companies with different capital structures, tax rates, and depreciation policies. By stripping EBIT of non-cash expenses, EBITDA is a good metric for comparing companies that are in similar markets. Even though EBITDA is a non-GAAP item, many firms routinely report it. But, because it is a non-GAAP item, companies have flexibility in how they report it.
Keep in mind, however, that EBITDA is not a measure of cash flow as it does not account for capital expenditures (purchases of long-lived assets to which the depreciation is allocated) or changes in net working capital (accounts for changes in receivables and payables related to credit sales).
EBITDA is sometimes mistaken as operating cash flow. It can be used as a quick proxy but it not the same as operating cash flow. Capital expenditures have to be deducted from EBITDA to compute cash flow. Additionally, EBITDA is based on gross profit, which has a non-cash component to it; this non-cash component also has to be adjusted for.
Now I will discuss different types of cash flows:
OCF: Operating cash flow
The expression for OCF is:
OCF = EBIT + Depreciation – Taxes
OCF is the cash that a company makes from its business operations. Taxes are viewed as an operating expense while interest is viewed as a finance expense (interest is viewed as a financing expense in financial analysis but in accounting, interest is considered an operating expense).
A positive OCF indicates that the cash inflows are greater than the cash outflows from daily business operations. A negative OCF is a worrisome sign. It is possible for a firm to have a positive net income but have negative OCF.
OCF is a better indicator of the cash that comes in from the regular business than EBIT. Why? Depreciation is a non-cash expense so it is added back and taxes are removed because they are considered an operating expense. These taxes correspond to the operating income; the company’s overall taxes may be more or less depending on the non-operating income or loss. As mentioned earlier, EBIT – Taxes is known as tax-effected EBIT, or NOPAT or EBIAT.
Cash Flow From Assets = OCF – CapEx – Increase in Net Working Capital
Cash flow from assets is the cash available for creditors and stockholders. In other words, the assets of a firm produce cash, which is used to pay bondholders and stockholders. As noted above, to determine cash flow from assets, OCF has to be adjusted to include changes in capital expenditures and net working capital. Why do have to make these adjustments?
The depreciation expense that is recorded is allocated over the life of long-lived assets such as property, plant, and equipment. If we add back depreciation, we must also account for the cash spent on equipment purchases called capital expenditures.
Net working capital is the difference between current assets and current liabilities. It refers to the amount of money on hand that can be used to pay off short-term obligations. Any increase in receivables will cause it to increase and any increase in payables will cause it to decrease and vice versa. So, why do we subtract an increase in working capital (non-cash)? Well, an increase in working capital indicates that receivables have increased more (or decreased less) relative to payables. Receivables are to be received later as the name indicates; they are not available now. This means if a firm’s receivables increase, it will have less money on hand now; this is why increases in working capital decrease cash flow from assets.
Another term, free cash flow (FCF), is used interchangeably with cash flow from assets. Free cash flow is also referred to as unlevered cash flow. This is cash flow from which debt expense has not been deducted. Because interest has not been deducted, both creditors and investors have residual claims on unlevered free cash flow. Some firms may have a negative free cash flow. This is not bad if these firms are heavily investing in capital expenditures that will generate cash flows in the future.
Levered cash flow is unlevered cash flow less interest expense.
Enterprise Value. Remember this one. It refers to the acquisition cost of a company; it’s the sum of the firm’s market capitalization and net debt.
Say you have an extraordinary sum of money earning you meager returns. This bores you. You take out a sizeable chunk and decide to buy a company. You do this by buying all of the company’s outstanding shares. You now have 100% ownership of the company. However, along with the ownership of the company, you also obtain responsibility for all of the company’s outstanding debt. You also get ownership of the cash the company has; this cash can be used to pay off some of the debt. Therefore, your acquisition cost of the company would be its market capitalization (the price you paid for buying all shares) plus its net debt.
A firm’s implied enterprise value can be found by discounting its projected future free cash flows using an appropriate cost of capital. If net debt is deducted from EV what remains is equity value. Equity value represents the total value of a firm that is available to owners (shareholders but not bondholders or government). This also includes the value of employee stock options which have yet to be exercised.
Equity value can be used to calculate an implied share price. Implied share price is obtained by dividing equity value by outstanding number of diluted shares (outstanding shares plus any stock options or convertible bonds). Why is it implied? It is implied because we are making the calculation based on our projections of the firm’s future cash flows. The market price of the stock is known. Comparing the implied equity price with the market price tells us if the company’s stock is under or over valued.
This ends my story about profit, cash flow, and value.