Company valuation tends to be one of the most important calculations for any company, simply because of the reason that it defines how much they are worth in the market.
It tends to be a highly important metric for investors, and other various stakeholders, because they are able to get an idea if their investment in the company is going to render positive returns for them in the near future.
Despite the fact that there are numerous different methods for company valuations, yet it can be seen that capitalized cash flow is one of the most commonly used methods of valuation.
Capitalized Cash Flow method can be described as a method that is used to value companies, depending on the cash flows of the company. This method mainly involves a single economic benefit being capitalized at the capitalization ratio, which subsequently provides the firms valuation at a certain date.
Here, the capitalization rate is defined as the spread between the required rate of return and the company’s expected growth rate.
This particular method to valuate companies is used when the company is expected to have relatively stabilized level of margins (and hence, cash flows), as well as growth in the future.
This particular method is described as an income-based approach to value companies, and it contingent on the projection that the company will have similar streams of income in the coming future.
Therefore, it can be seen that this particular method involves valuing business based on the existing cash flow stream that is subsequently capitalized by the risk-adjusted return.
The underlying premise in the Capitalized Cash Flow method is the fact that the company is perceived to be a growing perpetuity. The assumption here is the fact that the company will continue to grow at a constant rate.
Therefore, this particular approach is only valid for companies and organizations where the company is expected to grow at a constant rate.
In order to calculate the value of the company using Capitalized Cash Flow Model, the following formula is used:
Value of the company = (Expected Free Cash Flow of the Firm) / (WACC– expected growth rate)
The above formula is used in the case where Free Cash Flow is given, along with weighted average cost of capital for the company.
However, in the case where valuation is to be derived using Free Cash Flow to Equity, the formula changes. In that case, Free Cash Flow to Equity is divided by the spread between the required return of equity and the expected growth rate of the company.
Therefore, in this case, the following formula is used for calculating the value of the company:
Value of the company = (Free Cash Flow to Equity) / (Required Rate of Return on Equity – Expected growth rate of the company).
How to Value a Company Based on Capitalized Cash Flow Method?
The main steps taken when valuing a company using Capitalized Cash Flow Method are as follows:
Determination of a sustainable earnings base
Making necessary adjustments in order to convert projected earnings into projected cash flows (this also requires making adjustments for capital expenditures, depreciation, and changes in the working capital as well as other debt instruments.)
Figuring out a suitable capitalization rate
Application of the chosen capitalization rate in order to calculate the value of the company
The steps that are mentioned above are necessary in order to correctly evaluate the free cash flow, and then subsequently arriving at the valuation of the company.
Non-cash expenditures (like depreciation) need to be adjusted in order to arrive at a free and fair value of free cash flow. In the same manner, it is also important to have proper clarity about the growth rate of the company.
Example of Valuation using the Capitalized Cash Flow Method
In order to illustrate the steps mentioned above, the following illustration is provided:
Adjustments to the Net Income
Changes in Working Capital
Changes in Debt
Estimated Cash Flow
Projected Cash Flow Growth
Projected Cash Flow
Required Rate of Return
Value of Company’s Equity
Therefore, as per the example mentioned above, it can be seen that the value of the company’s equity, according to the Capitalized Cash Flow Method turns out to be $ 7,210,000.
In the process above, it can be seen that certain adjustments are made to the net income. This is because the premise of this particular method lies in using income, and then making adjustments to it in order to arrive at the value of the company’s equity.
A budgeted cash flow statement is not the same as the cash budget.
The cash budget plainly exhibits how much cash will be received or spent during
the year whereas the budgeted cash flow statement portraits the movement of
It gives a detailed explanation of how current assets or current liabilities become a major reason behind the difference in quick ratio and a current ratio of accounting analysis and how a non-cash transaction may deceive or confuse the reader about the profitability and liquidity of the business.
Hence, in order to keep the records clean, a separate budgeted statement of cash flow shall be prepared to portray how the budget plan is affecting the liquidity of the business.
If, for example, a purchase of better quality material is
resulting in better profitability but simultaneously the cash flow is
negatively being affected then such a policy would only harm the business.
Since the budgeted cash flow statement has identified this before
the policy was even implemented, the business can now try a different budget
plan and stay clear of any such liquidity crisis.
to prepare a budgeted cash flow statement?
As per the international accounting standards (IAS), a cash flow
statement shall constitute of three main heads namely:
Operating activities: These are all the main trading activities that a business performs to generate revenue. Operating activities include all working capital and non-cash adjustments that are to be made to the operating profit earned by the company in order to convert it from the accrual basis of accounting to the cash basis of accounting.
Investing activities: Investing activities reports all the money spent on investments in fixed assets or money received from the disposal of such assets.
Financing activities: This involves the money that a company raises or obtains in order to fund/finance the company as well as any transactions regarding dividends. Examples include obtaining a loan, issuance of shares, income dividends, etc.
When preparing a budgeted cash flow statement, the first thing you
need to know is the forecasted operating profit of the company.
This can be computed by preparing a budgeted income statement that
reports the projected sales and expenses respectively.
Secondly, all the working-capital adjustments shall be extracted
from the lower-level budgets i.e. the accounts receivable budget, accounts
payable budget, the production budget.
After the budgeted net cash flow from operating activities has been derived, the company shall report any assets it plans to purchase at its fair market value expected at that time or plans to dispose of.
These transactions must be based on an investment appraisal analysis resulting in a positive net present value, indicating that the investment will be profitable for the business.
Finally, any expected financing activities shall be reported. For example, the company plans to purchase a plant by raising money from the issuance of shares.
The money received from this transaction shall be added to the
financing activities section but deducted from the investing activities
Hence, the company shall estimate the market value of shares and fair market value of plants that will be in the future and report these transactions on the budget statement as per the future rates.
It has three different components in which all the changes are written down. There are two methods of making cash flow statement.
The internal Accounting standards prefer the direct method for preparation of statement of cash flow. But some organizations also use indirect method for their cash flow statement. The cash flow statement is divided in three parts. Which are
Cash flow from Operating
Cash flow from Investing
Cash flow from Financing
Net cash flow from these activities are net up with the profit/ loss value taken from the income statement.
And at the end previous balance of cash in hand in added up to determine the ending balance of cash. This statement also verify that the organization cash activities are free from errors and frauds.
Of Each Activity:
The operating activity is mostly made by the information gather from the current section of balance sheet.
It involves the changes from current receivables, current payable and inventory. These all are sum up to get the amount of cash flow generated from operating activities.
The investment activities involves the cash inflow and outflow of cash related to investment activities taken place in the period. These may include purchasing or selling of a fixed asset.
Financing Activities are generated from the changes in liabilities and capital side of the balance sheet.
The amount is positive if the activity generate cash inflow and negative when there is an outflow of cash due to the said activity.
Of Negative and Positive Cash Flow:
The cash flow coming from each activity sometimes result positive and sometime give negative result. It is not necessary that the outcome of cash flow from any activity must be positive.
Because it depends on the strategy of the business carried out by the management. Suppose if the company acquire loans or issue shares to the market.
It results in the positive cash flow. And when company boost their sales by offering credit to the market or increase their inventory level due to some reasons then it is possible that the cash flow from operating activities becomes negative.
Similarly the case is with the investing activities. If the company make purchase some fixed assets then the cash flow from investing activities may goes negative.
Negative Cash Flow From Investing Activities is bad?
Cash flow from investing activities is affected by selling and purchasing of any fixed asset of the company.
When the company buy any fixed asset during the period, it affects the cash flow negatively because there is an outflow of cash from the organization.
It is absolutely very normal activity because when u look at the balance sheet. The current asset is converted to a long term asset. The journal entry can give you more information about.
For Example. A company acquire a recycling
plant worth $200,000 and paid full in cash.
The entry will be:
Plant A/c $200,000
Cash A/c $200,000
It means that there is an outflow of cash $200,000 from the organization cash account.
The effect of this transaction in the cash flow statement will be like ($200,000) but by analyzing you can determine that only the company’s current asset is converted into Long term asset.
So we can say that the negative balance in very much positive in its effect. Because it gives increase in the company’s Fixed Asset. Which is useful for the company in the long run.
Everyone know that cash is the king either its small retail shop or large multinational organization. How large accrual income a business may be, but it might not be able to operate its operations without holding the sufficient cash.
Now, let’s have some brief idea what happens in a typical cash flow statement, there are three main parts of a cash flow statement,
Each of them tells you what exact amount is flowing into business (positive cash flow) and what exactly amount of cash is flowing from business (negative cash flow).
Also at the end of each part a subtotal is calculated, of course at end of statement three subtotals are summed up that lead to net cash flow for the period.
For the sake of standardization &
comparability for readers of the statement, International Accounting Standard
Board (IASB) has set an International Accounting Standard (IAS-07) that governs
this statement and provide the structure and reporting pattern.
Now, let’s figure out some more things of
the statement. At the beginning, there are some adjustments for the accruals
(non-cash income or expenses) of the period, like depreciation of fixed assets,
amortization of intangibles, impairment of goodwill, provisions, etc.
Effect of Goodwill on Cash Flow:
To understand how goodwill effects a cash flow statement, you first need figure out what goodwill is??
You don’t need to worry about the goodwill it’s quite simple thing. It’s an intangible asset.
How it’s measured??
When an entity acquires another entity or any of it asset(s) or group of assets (i.e. cash generating unit). And for that it pays a price significantly higher than the fair market value.
Goodwill = Consideration Paid – Market value of subject matter
After acquiring of business unit (or asset),
the entity – which purchased the other entity or its assets – recognize over
its balance sheet this difference under the name of ‘goodwill’. So, have
you seen how easy the concept of this thing is.
Now we’re gonna tell you some other aspects of the goodwill. Once it appears on the balance sheet of the entity its just start of the story. Every year, the entity have to make a test.
Test the goodwill, if it’s impaired (damaged) or not, if so, the amount of impairment needs to be estimated, and book this amount as an expense. Of course it’s purely an accrual (non-cash expense) entry.
Now let’s move to our topic that is adjustment on the cash flow. As you guys have notices that impairment is booked as expense and every expense reduce profit.
But an accrual does not affect the cash flow. That’s why when the accountant drafts the cash flow he/she adds back any impairment recorded during the period into profit of entity.
To illustrate the same concept, let’s have practical case. XYZ is an entity having opening balance goodwill of amount $ 2,000 as the period 20X9, and the impairment test comes positive with an amount of $ 450.
The income statement shows a net profit of $ 6,350 for the period 20X9. When cash flow statement is prepared the amount of impairment i.e. $ 450 is added back to profit i.e. $ 6,350.
And hence adjusted profit is calculated avoiding the effect of accrual i.e. $ 6,800.
It’s noteworthy that in various cases there may be no indication of goodwill. Definitely, in that case no adjustment is required in the cash flow statement.
In some cases, there may be a reversal of impairment in a subsequent year, but in case of purchased goodwill it cannot be reversed.
Further, if an entity is having losses (instead
of profits) the impairment is no added, rather it would be deducted from
As you have noticed, the goodwill is
something that cannot be disassociated from the thing it come with. Therefore,
it cannot be sold apart from that thing (asset or business).
Treasury stock is the share or stock that is repurchased by the company that issued them in the first place.
It reduces the paid-up capital and is also known as equity reduction. Treasury stock is recorded in the equity section of the balance sheet.
For example, a company has a paid-up capital of $200,000. It decides to repurchase 3000 shares at a value of $25. This means that the company will pay $75,000 to the existing shareholders and purchase back its stock.
The equity section will be reduced by $75,000 and would have a remaining balance of $125,000.
Simultaneously, the cash or cash equivalents balance would also be reduced by $75,000 in the balance sheet.
of Cash flow:
A cash flow statement is a financial statements that should be prepared as per IAS 07 by all companies annually.
It reports all the cash transactions that take place during a specific period of time (a month, a quarter or a year) and excludes any non-cash revenues or expenses recorded in the income statement.
A statement of cash flow accounts for every penny received or paid during the year and gives a clearer view of the financial stability and liquidity of a company.
According to the International Accounting Standards, a cash flow statement is to be prepared in the specified format so that it is easily understandable to any reader around the world. It is to be classified in three main heads as follows:
Cash flow from operating activities accounts for all the principle
transactions relating to the trading business. It includes any adjustments
relating to operating expenses and working capital adjustments.
Cash flow from investing activities involves any cash or cash
equivalents spent on investments, gains or losses from investments, purchase or
disposal of property, plant and equipment.
Cash flow from financing activities reports transactions relating to cash for funding the company through debt or equity and also involves payment of dividends.
It involves cash inflow or outflow from issuance or repurchase of equity, obtaining a loan or repayment of loan, issuing bonds or payment of dividends.
of treasury stock on statement of cash flow:
As mentioned above, treasury stock is a contra account of equity
and involves repurchase of the issued stock. In order to repurchase stock, the
company has to make payment to the existing shareholders resulting in a cash
This transaction is reported in the financing activities section
of the cash flow statement.
Similarly, if there is a sale of treasury stock, the company receives cash or cash equivalents against the shares from the new shareholder.
This is reported as a cash inflow in the financing activities section of the statement of cash flow.
A company has an equity balance of $25,000 for the fiscal year
ended 2018. In 2019, the company repurchases 500 shares from its issued capital
at a value of $10.
This would result in a reduction of equity from $25,000 to $20,000 in the balance sheet.
The cash outflow of $5,000 would be reported under the third section of the statement of cash flow i.e. cash flow from financing activities as follows:
Cash flow from financing activities: $
Purchase of treasury stock (5,000)
Net cash flow from financing activities (5,000)
A company has an equity balance of $100,000 which includes a treasury stock balance of $20,000 for the year ended 2018.
In 2019, the company decides to sell all its treasury stock and receives an amount of $20,000 against it.
This transaction increases the equity balance in the balance sheet for the year ended 2019 to $120,000 and the treasury stock account is reduced to zero.
In the cash flow statement, a cash inflow of $20,000 is reported in the financing activities section for the year ended 2019 in the following manner:
So it is very essential to keep record of all the cash inflow to the organization and outflow from the organization should be kept in a proper way.
In small business entities, there are no such restrictions on the format of cash flow. But for large companies and organizations, there is a proper format to be followed.
The format is described in IAS-7 and GAAP (FAS95). For every business entity the statement of cash flow should be made according to these standards.
The main purpose of making a statement of cash flow is to provide the information and compare the cash receipts and cash payments during a time period in which the entity run their business.
It also serves the same purpose as preparing other financial statements is to let the users understand well about the entity’s financial situation only financial performance and position, but also the cash flow.
Classification of Statement of Cash
According to IAS-7, the cash flow of every organization flows under the three main heads. It means all the transactions are should be classified under these three activities.
These are the main activities in an organization which are the reasons of changes come in cash and cash equivalents.
Each activity provide the different the information of entity’s cash flow with different purpose. Operating activities will let the users know whether the entity have the positive or negative cash flow as well as the movement of each items of working capital.
The purpose of preparing cash in the investing activities is to let the users know what are the items that entity has the hug investment in and what are the items that entity relax to invest.
Importance of Statement of Cash Flow:
Organizations using accrual methods of accounting to record their transactions. And all the financial statements are based on this information.
That’s why besides from statement of cash flow no financial report is providing the actual information about the cash inflows and outflows.
suppose an organization is running its business with high level of inventory
and fixed assets along with high credit sales.
By analyzing balance sheet and Profit & loss statement you can say that the company is in a very stable position.
But on the other hand, there is not enough cash available to meet the expenses of the organization. Which may result in bankruptcy or decline in business of the company. Let’s study an example to understand it fully.
XYZ is running its business in New York City. The balance sheet shows Assets side $400,000 with a cash balance of $2000 and receivables amounting to $70,000. While the liability side shows payable of net $40,000.
Projected sales for the next month are amounting to $60,000 with an expected $50,000 credit sales. There is no chance of converting current receivables into cash.
If we analyze the above information we will say that company is in a very profitable mood with high sales. But when you make Cash current cash flow and projected cash flow for the next month it will say that there will be not enough money to pay current payables of $40,000.
the managers have to adopt some strategy to counter the shortfall of cash. You
can get this information only by statement of cash flow.
Cash flow for Decision Making:
In the previous example, we study how the cash flow statement is important for the company’s management to take their decisions and planning for the next business period. The cash flow statement is also important for the following persons
all the persons or organizations who want to invest in an organization. As it
shows the company position to pay their current and long term payables.
Investors value statement of cash flow the most when looking to invest in
report is always helpful to the creditors of a company. Because they use this
report to decide whether it is feasible to go extent the credit limit of the
company or should it be limit as the company cash flow shows negativity.
So as part of the financial statements, It is
equally important to all the stakeholders of an organization.