CREDIT FUNDAMENTALS

Free Flow: Free to Do What?

by Mark J. Zoeller hy don’t more lenders use free as a tool in credit analysis? Maybe it stems in part from the variety Wof meanings given to the term. This article provides background to some of the variety of meanings of and then offers three examples of using FCF in credit analysis. In addition, some of EBITDA’s nasty little secrets, revealed in past Journal articles, are confirmed.

t’s time. Although the aca- to help measure repayment risk. did not include bond maturities demic and investment com- What may have stopped some because the assumption was that I munities have used free cash lenders from using FCF is the principal could be refinanced. flow (FCF) in credit analyses for term itself—it’s confusing because Lenders use several cov- several years, I have yet to see it has taken on a variety of mean- erage ratios, and the banking lenders commonly use it. ings. The calculations, however, industry has no standard ratio that FCF is the remaining (free) are reasonably simple. everybody uses. Some ratios amount of annual after-tax cash measure interest coverage only. flow generated by internal opera- Debt Service Coverage Ratios Others include the current portion tions after making needed invest- In its 1909 Moody’s Manual of of term debt (CPLTD). Yet others ments. It is the annual cash flow Railroads and Corporation include additional fixed charges. available to repay debt, pay divi- Securities, Moody’s presented an Some are pre-tax, some are post- dends, and buy back stock. Thus, inverted debt service coverage tax, and some are mixed. lenders can use it as a primary tool ratio (DSCR) of fixed charges as a Most commercial spreadsheet to better understand commercial percentage of income. Fixed programs show the Uniform and industrial borrowers’ ability to charges included interest expense Credit Analysis ratio of Net Cash service their long-term and and sinking fund payments. They after Operations (NCAO-post tax)

© 2002 by RMA. Zoeller is a banking consultant in Fresno, California, following 22 years as a regional credit administrator and loan officer in Los Angeles and 10 years with the Office of the Comptroller of the Currency, Washington, D.C., as a credit examiner.

34 The RMA Journal March 2002 Free Cash Flow: Free to Do What? divided by the sum of CPLTD cash flow. My interpretation of the Free Cash Flow (post-tax) plus Interest Expense 10 points, as outlined by Pamela In the 1970s, G. Bennett (pre-tax). Stumpp, is that when used as the Stewart III of Stern Stewart & Co. Income taxes complicate cov- primary measurement of cash gave FCF its name and method of erage calculations because, for flow, EBITDA: calculation. The firm subsequent- tax-paying corporations, interest is 1. Fails to consider the growth ly also gave us the Economic paid in pre-tax dollars while prin- of working capital as a com- Value Added (EVATM) concept. In cipal is paid in post-tax dollars. If peting use of cash. his 1991 book, The Quest For Value, the calculation uses Net Profit 2. Inadequately measures liq- Stewart stated that FCF equals After Taxes (NPAT) then, logical- uidity because it does not Net Operating Profit After Tax ly, interest should be adjusted to deal with cash flow timing, (NOPAT) minus investments in post-tax dollars. If the calculation the ability of subsidiaries to increased working capital and uses Net Profit Before Taxes upstream cash, or the impor- growth capital expenditures (NPBT), then principal should be tance of other loan-agreement (CAPEX). His NOPAT deducted adjusted. The most common cal- covenants. depreciation and taxes paid, not culations today are pre-tax. 3. Omits needed reinvestments, the tax expense. He deducted In recent years, lenders and particularly if the asset is depreciation because it can be a investment analysts have been short lived or the assets are measure of the CAPEX needed to using Earnings Before Interest, increasing in . sustain operations. Taxes, Depreciation, and 4. Does not consider the quality If the FCF is negative, the Amortization (EBITDA) as the of earnings. company must cover the negative basic measure of cash flow avail- 5. Inadequately measures com- amount by borrowing money, sell- able to cover debt. However, parable acquisition multiples ing stock, leaning on trade credi- EBITDA has major flaws. because actual cash flow tors, or selling assets. • It is pre-tax while the actual dynamics and balance sheet Thus, FCF is a broad meas- cash available to pay principal dynamics also play important ure, covering virtually all corpo- is after taxes. roles. rate activities. Stewart’s FCF con- • It does not consider fixed- 6. Ignores differences in cept has been widely adopted, asset purchases. accounting principles although also widely modified. In • It does not recognize that between otherwise compara- his 2000 book, The EVA Challenge, sales increases require ble entities. Joel Stern (the Stern of Stern increased amounts of working 7. Ignores accounting differ- Stewart) used a modified NOPAT capital. ences across borders. calculation. McKinsey & • Generally accepted account- 8. Inadequately offers protection Company, Inc.’s book Valuation: ing principles allow large vari- in indenture covenants due to Measuring and Managing the Value of ations in earnings and possi- differing interpretations of Companies, 3rd edition published bly manipulation. FCF is not what does and does not in 2000 (coauthored by Tim as subject to manipulation. belong in EBITDA. Capital Copeland, Tim Koller, and Jack Payment of taxes, purchases gains on recurring asset sales Murrin), presents a modified FCF of fixed assets and other invest- is an example. used to value corporations. ments, and increased working 9. Can drift from the realm of Some modifications stray far capital all compete for the same reality because it can lead to from Stewart’s original concept. dollars that would otherwise be disastrous expense cuts, such Most formulations do not distin- used to repay principal, pay divi- as marketing, and because it guish between maintenance dends, or repurchase stock. In a can depend heavily on the CAPEX and growth CAPEX. 2000 Special Comment, Moody’s capital gains from asset sales. They include all CAPEX because described 10 failures of EBITDA 10. Ignores the unique attributes many companies may have to as the principal determinant of of many industries. grow to remain competitive.

35 Free Cash Flow: Free to Do What?

Others use the basic concept, company as a whole and FCF of concepts, however, does not but also call it something else. available to stockholders. For the consider the cash flow tied up in Bartley Madden, a partner in Holt purposes of this article, our pri- increasing working capital Value Associates, in his 1999 mary interest is FCF available to requirements. book, CFROI Valuation: A Total the company as a whole. Even if a company could sus- System Approach to Valuing the Some within the lending and tain itself in the near term with Firm, calls it “Capital Suppliers’ investment worlds have attempt- only a maintenance level of Net Cash Receipts.” RMA uses a ed to merge the EBITDA concept CAPEX, determining that amount slightly modified calculation in its into the FCF concept by subtract- is difficult. Borrowers often can- “Corporate Valuation for ing “maintenance CAPEX” from not do it with accuracy, and Lenders” course and calls it “cash EBITDA. Subtracting total lenders often cannot do it either. flow for security holders.” Robert CAPEX expenditures from Lenders usually have to resort to Hagstrom Jr., in his 1994 book, EBITDA and calling it FCF is some formula amount or use the The Warren Buffet Way, writes that common. Barron’s, in its depreciation expense as a proxy. Buffet calls plus November 6, 1995 issue, for Lenders also do recognize depreciation, depletion, and amor- example, reported that CAPEX as a risk and typically tization minus needed working Oppenheimer & Co. used it as restrict them in loan agreements. capital increases and capital FCF. An article in the June 2001 expenditures “owner earnings.” RMA Journal defined FCF as Free Cash Flow and a Debt Investment magazines use a vari- EBITDA minus “at-least-annual- Service Coverage Ratio ety of FCF definitions. Several ly-recurring mandatory capital I prefer to calculate FCF by financial and valuation books dis- expenditures.” Moody’s, in a vari- using the GAAP version of Net cuss variations of the concept in ety of publications, states that Cash Provided by Operating detail. Some books differentiate EBITDA minus CAPEX is a fac- Activities (NCPOA) as the starting between FCF available to the tor in bond ratings. This merger point. Others might prefer to begin with the UCA funds Company A ($000,000) statement data. Year Year Year Year Ended Ended Ended Ended NCPOA minus 12/31/1997 12/31/1998 12/31/1999 12/31/2000 CAPEX minus other Free Cash Flow Net Income 3,047 3,164 3,856 4,047 investment items Add: Depreciation, Depletion & Amortization 2,501 2,496 3,293 2,498 from the funds state- Add: Other Operating Cash Flow Items (180) (434) (2,752) (382) ment is a useful ver- Decrease (Increase) Operating Working Capital (935) (590) 659 (1,526) Net Cash Provided by Operating Activities (NCPOA) 4,433 4,636 5,056 4,637 sion of FCF, and I Deduct: Capital Expenditures 3,397 3,260 2,980 2,808 will call it FCF. Deduct: Other Investments (Investment Sales) (319) (195) (2,145) (684) NCPOA is net of Free Cash Flow (FCF) 1,355 1,571 4,221 2,513 Add: Interest Expense Net of Tax Benefit 119 107 125 107 interest expense, FCF Available to Service Debt 1,474 1,678 4,346 2,620 operating working Debt Service Requirements capital changes, and Interest Expense Net of Tax Benefit 119 107 125 107 Current Portion Long-Term Debt Due During Year 1,474 1,325 income taxes paid. Total Debt Service Requirements 119 1,581 1,450 107 The tables FCF DSCR 12.4x 1.1x 3.0x 24.5x appearing on these Additional Information Beginning Book Net Worth 10,814 9,908 9,717 10,256 two pages show cal- NCPOA minus Depreciation/Beginning Book NW 17.9% 21.6% 18.1% 20.9% culations for three EBIT/Interest Expense 12.5 x 12.9x 16.4x 16.2x Dividends 392 417 440 465 publicly held corpo- FCF minus CPLTD minus Dividends 963 (320) 2,457 2,048 rations. To arrive at a New Equity (Equity Repurchases) (1) (3,142) (3,323) (3,037) DSCR, I used the New Debt 1,972 2,536 775 322 Debt Ratings Investment Investment sum of FCF plus Grade Grade interest expense net

36 The RMA Journal March 2002 Free Cash Flow: Free to Do What?

Company B ($000,000) Annualized Year Year Year Year Year Ended Ended Ended Ended Ended 12/31/1997 12/31/1998 12/31/1999 12/31/2000 12/31/2001 Free Cash Flow Net Income ( 190.1) (76.5) 13.1 56.6 (602.4) Add: Depreciation, Depletion & Amortization 167.3 136.1 158.9 170.9 165.0 Add: Other Operating Cash Flow Items 408.3 (40.5) (15.6) (155.9) 157.5 Decrease (Increase) Operating Working Capital (202.4) 127.5 40.8 (72.3) 181.8 Net Cash Provided by Operating Activities (NCPOA) 183.1 146.6 197.2 (0.7) (98.1) Deduct: Capital Expenditures 201.5 286.7 255.8 193.8 100.2 Deduct: Other Investments (Investment Sales) 35.7 (159.5) (79.7) (91.7) (159.0) Free Cash Flow (FCF) before Interest (54.1) 19.4 21.1 (102.8) (39.3) Add: Interest Expense Net of Tax Benefit 24.0 (27.0) 42.0 45.0 143.7 FCF Available to Service Debt (30.1) (7.6) 63.1 (57.8) 104.4 Debt Service Requirements Interest Expense Net of Tax Benefit 24.0 (27.0) 42.0 45.0 143.7 Current Portion Long-Term Debt Due During Year 56.6 Total Debt Service Requirements 80.6 (27.0) 42.0 45.0 143.7 FCF DSCR -0.4x 0.3x 1.5x -1.3x 0.7x Additional Information Beginning Book Net Worth 987.3 726.6 584.9 555.8 562.8 NCPOA minus Depreciation/Beginning Book NW 1.6% 1.4% 6.5% -30.9% -46.7% EBIT/Interest Expense (3.3)x (0.9)x 1.4x 1.3x (3.5)x Net Profit After Taxes plus Depreciation (22.8) 59.6 172.0 227.5 (437.4) Dividends 40.7 39.8 39.9 40.5 0 FCF minus Debt Service minus Dividends (151.4) (20.4) (18.8) (143.3) (39.3) New Equity (Equity Repurchases) (38.6) (59.3) 0.5 0.2 0 New Debt - Short Term 132.5 130.5 0 162.3 74.4 Debt Ratings Junk Junk Default

of the tax benefit as Company C ($000,000) Year Year Year Year the numerator divid- Ended Ended Ended Ended ed by the sum of 01/31/1998 01/31/1999 01/31/2000 01/31/2001 principal due during Free Cash Flow Net Income 2,468 3,101 3,764 4,407 the year plus interest Add: Depreciation, Depletion & Amortization 1,144 1,310 1,663 2,008 net of the tax bene- Add: Other Operating Cash Flow Items 14 (448) 42 239 fit. For this article I Deduct: Increase (Decrease) Operating Working Capital 1,360 1,343 267 69 Net Cash Provided by Operating Activities (NCPOA) 4,986 5,306 5,736 6,723 have tried to dis- Deduct: Capital Expenditures 1,846 2,614 4,328 5,629 guise the publicly Deduct: Other Investments 1,250 479 7,443 470 Free Cash Flow (FCF) before Interest 1,890 2,213 (6,035) 624 available numbers Add: Interest Expense Net of Tax Benefit 346 349 453 613 from the SEC’s FCF Available to Service Debt 2,236 2,562 (5,582) 1,237 EDGAR website. Debt Service Requirements Interest Expense Net of Tax Benefit 346 349 453 613 My comments about Current Portion Long-Term Debt Due During Year 433 799 704 1,460 the companies are Total Debt Service Requirements 779 1,148 1,157 2,073 far from complete FCF DSCR 2.9x 2.2x (4.8)x 0.6x Additional Information analyses. Beginning Book Net Worth 12,000 12,952 14,778 18,084 The tables NCPOA minus Depreciation/Beginning Book NW 32.0% 30.8% 27.6% 26.1% reveal the following: EBIT/Interest Expense 8.3x 10.2x 9.9x 8.4x Dividends 428 485 623 749 • All of the compa- FCF minus Debt Service minus Dividends 1,029 929 (7,362) (1,585) nies had large swings New Equity (Equity Repurchases) (1,098) (841) (71) 272 in FCF and DSCR. New Debt 362 351 7,228 1,504 Debt Ratings Strong Strong • Company A has Investment Investment considerable recur- Grade Grade ring FCF with usual- 37 Free Cash Flow: Free to Do What?

ly high DSCR. It has used its • For Company B, I show an debt trap where the debt could FCF largely to repurchase old lending standard, NPAT never actually be repaid. shares. Although the compa- plus depreciation Company C has a bright ny’s most recent year-end These additional calculations future while Company B’s future statement showed no show that even when subtracting is in the hands of a bankruptcy CPLTD, it will have it in the depreciation from NCPOA, court. future. But it could reduce its Company C generates more than Although other things can share repurchases to apply a 25% annual after-tax cash return influence the ability to repay cash to debt repayment. on net worth. Compare that with debt, lenders need to follow the • Company B, in three of its Company B’s nominal or negative trend in the FCF DSCR. four years, has had nominal or cash returns on net worth. Although a borrower can mitigate slightly negative FCF with Company C used high levels of the risk as shown in Company C, DSCR negative or less than CAPEX and other investments in lenders still need to know 1.0x. It recently filed Chapter fiscal 2000 and 2001 to generate whether or not a borrower fully 11 bankruptcy. high levels of cash return on equi- funds its cash needs by its inter- • Company B has no CPLTD ty while Company B’s CAPEX nal operations. Trends can be because all of the recent debt have produced little or negative more important than a given ratio incurred is short term. If this cash return. at any specific date or for any spe- debt were amortized, the The DSCR measures the rela- cific period. However, lenders also DSCR would be even lower. tive level of risk that a company need to analyze single-date or • Company C has had fluctuat- needs to find financing outside of single-period ratios because they ing FCF with one negative operations. Company C has offset may be showing major changes DSCR also with one DSCR the risk from its negative FCF by taking place. A single ratio may be less than 1.0x. Yet this compa- maintaining a strong external the beginning of a new trend, and ny is a highly regarded compa- financing ability and has mini- the credit analysis needs to meas- ny with a strong bond rating. mized the need for external funds ure the probability that a new Company B and Company C, by imposing strong controls on trend is or is not occurring. on the surface, have some similar- working capital. Its investment in In Company B’s situation, the ities in their FCF and DSCR, so operating working capital has EBIT to interest expense ratio why the difference in perceived decreased even as the company still showed a 1.3x ratio in 2000. risk levels? Remember that FCF grows. The credit markets recog- The FCF and its DSCR, howev- measures internally generated nize that its strong competitive er, showed negative and proved to cash flow. Any cash flow measure- advantage allows its CAPEX and be more timely measures of the ment, even FCF, is but one tool to investments to generate strong severely negative circumstances use in an analysis. It is not the NCPOA that will turn into strong, ahead in 2001. only tool in the tool chest. To sustainable FCF. In the critical years 1998, help draw some additional com- In Company B’s case, its 1999, and 2000, the old lending parisons I have included other cal- CAPEX have not generated what standard of NPAT plus deprecia- culations, for example: debt or equity investors are look- tion showed a positive trend, • EBIT divided by interest ex- ing for. Its sales have decreased, which, in the end, proved to be pense. This is a traditional and its performance in calendar misleading. ratio used in the bond indus- 2000 showed a reversion to nega- try. tive FCF, even after some invest- Other Considerations • NCPOA minus depreciation ment assets were sold. It was even To effectively use FCF, divided by beginning net borrowing short term to pay divi- lenders need to consider the worth. I subtracted deprecia- dends. The risk had become that effects of numerous other financial tion because it can be a meas- the company had entered into a circumstances, some of which have ure of maintenance CAPEX. permanently downward spiraling already been mentioned. Other

38 The RMA Journal March 2002 Free Cash Flow: Free to Do What? considerations are too numerous used historical numbers as a rower needs external financing, and too complicated to go into measure of what the future lenders need to understand the here. However, the following sum- might be. However, FCF can risk involved in obtaining that marizes several of them: certainly be done as a part of financing. With Company B the • Many C&I borrowers are projections. risk became high. With Company partnerships, Subchapter S • Consolidated and combined C the risk is low. But as with all corporations, or limited liabili- financial statements do not ratios we will need to consider ty companies. These entities necessarily show where the many other financial circum- do not pay taxes; the owners cash is actually generated, stances, such as trends, other ana- pay the taxes. Thus, all FCF whether it can be upstreamed lytical measures, dividends, pro- components will be pre-tax. or side-streamed, and jections, unaudited financial state- • Despite the legal priority of whether it is where the debt ments, consolidated financial data, debt payments over divi- service requirements are. extraordinary items, the borrow- dends, stock repurchases, and • Extraordinary items may not er’s industry and competition, etc. payments to partners, these be so extraordinary. If a com- to get a complete picture. ❐ latter three may be almost pany has extraordinary items mandatory. In normal circum- year after year, an analysis Zoeller may be contacted by e-mail at stances, after providing for should consider them as [email protected] working capital growth, these recurring rather than non- cash uses compete with prin- recurring. Notes cipal payments for the cash • Is the borrower’s industry sta- The following articles have good discussions of cash flows—the author recommends that all flow available. Thus, adjust- ble, rapidly changing, new, lenders read them: ing the DSCR calculation by mature, dying? Or is the com- subtracting them from FCF petition making the borrow- Richard A. Hamm, “How to Compute DSC? Let Us Count the Ways,” The Journal of Lending & Credit (or placing them in the er’s product(s) irrelevant? Risk Management, May 1999, beginning on p. 54. denominator of the FCF Lenders need to know how John Cassis, “Hide & Seek:There’s hidden cash out- DSCR ratio calculation) may rapidly cash flows can change. flow in mandatory capital expenditures that recur be reasonable and necessary. at least annually,” The RMA Journal, June 2001, beginning on p. 48. For publicly held corpora- Conclusions tions, eliminating or reducing The banking industry has Frank DiLorenzo, “Getting Behind the Numbers,” The RMA Journal, July/August 2001, beginning on a dividend is often the sign of several debt service and fixed p.74. a company in trouble. In charge coverage ratios available. Pamela M. Stumpp, “Putting EBITDA In other circumstances, pre- However, many have weaknesses Perspective: Ten Critical Failings of EBITDA As the ferred dividends paid by a or limitations, such as combining Principal Determinant of Cash Flow, “ Moody’s Investors Service, June 2000, published on the non-wholly owned subsidiary post-tax items with pre-tax items. Internet. can be almost impossible to EBITDA has the weakness of not Dean W. Duelke, “The Importance of Accrual stop. In privately held compa- considering increases in working Profits,” The Journal of Lending & Credit Risk nies, the owner(s) may need capital, CAPEX, and other invest- Management, February 2000, beginning on p. 82. the payments to pay taxes. ments. By definition, FCF meas- • Interest and CPLTD need to ures the internal cash flow gener- include interest on leases and ated by operations available to the CPLTD of leases. repay principal, pay dividends, • Unaudited financial state- and buy back stock. A FCF-based ments often lack a funds DSCR, beginning with the GAAP statement and may lack criti- NCPOA, measures the relative cal information needed to cal- level of risk that operations will culate FCF. not provide for all of its needs. If • To calculate the DSCR, I the measure shows that the bor-

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