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Learn Financial Modeling : Discounted Cash Flow statement (DCF) Methodology

2. Start building our free cash flow statement

If you created a model before you know that you might have a financial statement model that precedes the DCF Analysis and in that model you have a forecast cash flow statement so you should wondering why do i even need to do a free cash flow build-up if I have that basic FSM ? The answer is that cash flow from operation does not include the capital expenditure and we know that free cash flow by definition is operating profit less reinvestment being capital expenditures so while this items (Account payable / inventories ...) it is missing a critical element which is CAPEX (capital expenditure) so that is why we need a cash flow build-up as you see here.

The next thing that you're probably wondering is why we forecasted for 5 years the real answer is well it depends on when your company has stable earnings so we're assuming that in five years the company will have stable earnings so typically practitioners forecast cash flows anywhere between five and teen years and even if you've got a company that is mature like a coca-cola Procter & Gamble or GE it's still recommended that you do five years so you can see the cash flow build-up now that we understand sort of what the section entails it let's go ahead and start building it so we're going to go ahead and reference revenues from our select operating data schedule

I'm going to do the same thing with EBITDA da as well as EBIT again this is an unlevered free cash flow analysis so it's before the payments of debt now given that taxes are not an optional thing you have to pay taxes to the government we're going to focus on EBIAT which is earnings before interest after taxes so we take a EBIT and we multiply by one minus the tax rate to find the after-tax value of EBIT another word for EBIAT that you might hear is NOPAT and that's net operating profit after taxes next in order to go from EBIAT to to unlevered free cash flows we need to make several adjustments those adjustments include adding back non-cash expenses and subtracting out non-cash gains making our accrual adjustments and then subtracting out our reinvestment which is capital expenditures

So first thing we're going to do is we're going to add back our non-cash expenses which in our case is just D&A now as you recall when we when you build a cash flow statement an increase in an asset is viewed as a use of cash while an increase in liabilities or equity is viewed as a source of cash now I know that accounts receivable when we increase that it's hard to really picture why that's a use of cash so I'm going to explain it from a different angle here and that is that we know that from cash versus accrual accounting revenues includes both sales made on credit as well as sales made on with cash so in other words if our credit sales increase that's going to indeed increase revenue but we know that we're not actually receiving that cash yet we're going to receive it at a later point in the future so if our accounts receivable goes up we need to make the necessary adjustments to EBIAT to reflect the actual cash that is coming in which is only cash sales so therefore an increase in accounts receivable will need to be deducted from EBIAT to correctly reflect cash coming in so one way to do this would be to do the first forecasted year minus the previous year but you need to make sure to add a negative sign to that value otherwise you won't have the correct signage now what I'm going to do is I'm going to do previous year - the first forecasted here because that will automatically embed the sign now accounts payable being a liability an increase in that represent a source of cash so I'm going to do first forecasted period minus previous forecasted period

Now regarding capital expenditures they are an asset so an increase represents a use of cash okay now what we need to do is we're going to add EBIAT D&A and our working capital adjustments as well as capex the present value of free cash flows which is unlevered free cash flow divided by 1 plus WACC raised to the period. so as you can see we've now built up our free cash flow for the explicit forecasted period ie stage one and it's now time to focus on what we call stage two which is the terminal value. Remember that we still missing the WACC to go from Free Cash Flow to Present Value of Free Cash flow and we are going to calculate it after the terminal value which is next PART 3