Cash Flow Modelling
Cash flow modelling is an essential element of valuing a business. What cash is this business going to generate for the firm and for equity holders in the business. The value of the business is a function of the future cash flows.
Often, we talk of Free Cash Flow to the Firm (FCFF).FCFF comprises revenue, less associated costs of sales, overheads (excluding interest), expected working capital requirements, capital maintenance and improvement expenses and tax expenses. The FCFF is available to both debt holders and equity holders.
Cash flows are often modelled for a period of five years. The period of modelling depends though on factors such as growth, earnings volatility and if there are fixed contracts or fixed project periods. In some instances, earnings may be so stable that no cash flow modelling is required.
Cash flow modelling requires making assumptions. Typical assumptions relate to:
- how revenue is expected to grow each year
- future gross profit margins
- expected overhead expenses
- expected working capital and capital expenditure
- inflation rate
Assumptions need to be built on the foundations of facts. On some tangible evidence.
Future revenue projections can be influenced by many factors, including:
- past revenue growth
- current market share and the size of the potential market
- industry growth expectations
- competitor landscape
- expected changes in legislation
- economic outlook
- introduction of new products and services
- ability to increase prices and price elasticity
Expense projectionscan by influenced by factors such as:
- past gross profit margins and expenses
- anticipated increasing the number of staff or making productivity improvements
- expected new offices
- outlook for commodity prices and exchange rates
- anticipated investment in new machinery or replacing old machinery
- expected improvements in collecting receivable and lowering stock levels