Precedent Transaction Analysis
Investment bankers use several different types of methodologies while arriving at the valuation of a company. One of the most commonly used analysis is called precedent transaction analysis. What is Precedent Transaction Analysis? Precedent transaction analysis is a relative valuation methodology, just like comparables analysis. This means that these methodologies do not derive the value […]
3 Modern Financial Management Techniques that Will Change Your Business
Whether you’re a business or an individual, you have to find a way to manage your finances now and in the future. The cost of everything continues to increase and there’s no sign that this trend of price increases will stop anytime soon. As a result, all entities have to develop a financial management system […]
The Founder’s Dilemma – Startup Finance
Entrepreneurship is all about making decisions in the face of uncertainty. Entrepreneurship involves beginning a journey that the founder does not currently have the resources to complete. For instance, when any start-up is first formed it does not have the money, assets, or human capital required to create value. It is the central job of […]
Cross Border Credit Reporting
The geographical boundaries drawn by nation states are blurring in the 21st century. In many parts of the world, free movement of goods, services, and even personnel have become a norm. However, strangely, the concept of credit and loans is still dependent upon national boundaries. The H1B visa system of America is a testimony to […]
Replacement Cost Approach Advantages and Disadvantages
In the previous article, we have already witnessed what replacement cost theory is and how it can be used to value sporting franchises. We now know the theoretical aspects of this type of valuation. We also know that the replacement cost approach is not used very widely when it comes to the valuation of sports […]
The free cash flow to operating cash flow ratio is different from other ratios. It is different in the sense that it is comparing two measures of cash flow. Usually cash flow ratios compare a cash flow item to an item on the income statement or on the balance sheet. Here are the details of this ratio:
The terms used in the ratio i.e. operating cash flow as well as free cash flow have been described in the cash flow section. But here is a quick refresher.
Operating Cash Flow: Operating cash flow is considered by many to be the most appropriate measure of cash flow. It measures the cash flow that the company has been able to generate from its regular day to day operations. Cash flow generated from onetime events such as sale of assets and investments is not a part of this. Hence investors can expect this cash flow to continue in the next period.
Free Cash Flow: Free cash flow is not listed on the cash flow statement. Rather it is derived by subtracting the capital expenditure from operating cash flow. This measure is important because this is the amount of cash flow that the investors have left after meeting the growth needs of the firm.
The name of the ratio pretty much gives away the formula. The formula is as follows:
Free Cash Flow to Operating Cash Flow Ratio = Free Cash Flow / Operating Cash Flow
This ratio tells the investors about how much free cash flow is being generated for every rupee of operating cash flow. A higher ratio means company is not investing too much in capital expenditure and therefore maybe a mature company that is not seeking any more growth but rather seeking to sustain its operations.
Mature stable firms do not need to make too many capital investments and thus have a higher ratio. On the other hand companies that are growing will have a lower ratio. One needs to start questioning if mature companies have lower ratios or vice versa.
A company with a high gestation period will invest more and more each year, the effects of which will not be visible in the free cash flow to operating cash flow ratio until many years.
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