Calculating Free Cash Flow to Firm: Method 3: EBIT

In the previous articles, we learned about how to calculate the cash flow from operations if the cash flow statement or the income statement were given in the question paper. In many cases, these financial statements may not be given in full in the question paper.

Instead, some excerpts from these statements may be provided in the question paper. One such example is when Earnings before Interest and Taxes (EBIT) is provided. Hence, we have to begin our calculation with EBIT and derive the free cash flow to the firm based on the supplementary information. This article will describe this process in detail.

It is important to understand the logic behind the formulas. Mindless rote learning of the formula may cause the students to forget the formulas or get confused. If the concepts are clear, students can derive the formulas themselves as and when required.

Here is a step by step procedure to calculate the free cash flow to the firm from EBIT.

Depreciation is a non cash expense. It has been reduced from the revenues to arrive at EBIT. Hence, to derive what the true cash flow of the firm is, we need to add back the depreciation amount. This is the standard procedure we use while preparing any cash flow statement.

Step 2 is where things get slightly complicated. Now, notice the fact that we are working with EBIT which is earnings before interest and taxes. This means that we haven’t accounted for interest as well as taxes and their effects on the cash flow.

Interest does not have any effect on the cash flow. We haven’t subtracted it from EBIT and hence there is no need to add it back.

Taxes on the other hand are a different matter. They are a cash outflow which occurs at a later stage in the income statement. Hence, while deriving free cash flows to the firm we must adjust the EBIT for taxes. This is done by subtracting the tax amount from EBIT.

For example, the EBIT was $1000 and there was a 40% tax rate. At a later stage on the income statement, the company will pay 40% of this $1000 as cash flow. Hence, its EBIT will be reduced to $600. We therefore need to adjust the EBIT for taxes and make it a post tax EBIT number.

Step 3 is the standard procedure we use to calculate free cash flow to the firm. Here, we will subtract our working capital and fixed capital investments from the amount derived by performing step 1 and step 2. The complications that may arise while doing so have been discussed in earlier articles.

These three steps can be summarized in the following formula:

The fourth method of calculating free cash flows is closely related to the third method. Here too we are being provided with excerpts from the income statement. Instead of being provided with the EBIT number, we are provided with the EBIDTA number.

EBITDA stands for Earnings before interest, tax, depreciation and amortization. As we can see this appears even further up on the income statement as compared to the EBIT number.

Here even the depreciation has not been subtracted. Hence there is a slight change in the step 1 that we followed above.

Since the depreciation amount has not been deducted, there is no need to add it back. However, the depreciation amount does reduce the tax bill of the company. Hence, we need to add back the depreciation tax shield to find out the true free cash flow that will accrue to the firm.

Notice the difference. When we were given EBIT, we added back the entire depreciation amount. In this case we will only add back the tax shield provided by the depreciation.

For example, if the depreciation amount was $200 and the prevailing tax rate is 40%, we will add back only $80 i.e. ($200*0.4) and not the entire $200 as we did in the earlier case.

Apart from this, steps 2 and 3 need to be repeated exactly as they were in the above case.

This method can be summarized in the following formula:

The thumb rule in these cases is to adjust for any non cash changes above the income statement metric that you have been provided. All non cash changed below the metric must be ignored or only adjusted for taxation.

It is for this reason that we added back the entire depreciation amount in case of EBIT. (Depreciation appears above EBIT on the income statement) whereas we add only the depreciation tax shield in the case of EBIDTA (Depreciation appears after EBIDTA on the income statement)

Thus, we can derive free cash flow to the firm from a wide variety of metrics. We could use the cash flow statement, the income statement or even some selected information from the income statement.