Cash generation, reinvestment and coverage

Learning goals

• Interpret common-size cash flows and sustainable funding.
• Compute FCFF, FCFE and explicitly defined coverage measures.

Draft · approximately 80 minutes, excluding further revision.

Explain the source of a strong cash year

Analyze cash receipts and payments over several years, using a stated common-size denominator such as revenue or total cash inflows. CFO/revenue measures operating cash margin under the reporting classification. A positive CFO from reducing inventory or stretching payables can be temporary; a negative CFO from productive growth can still require financing and carry collection risk.

Separate maintenance needs from expansion assumptions and review whether operating cash funds capital expenditure, debt service and distributions. Repeated asset disposals or new borrowing can fund dividends while operations weaken. Net cash change alone conceals the mix, so reconcile all three cash-flow categories before judging sustainability.

Match free cash flow to its claimholders

In a simple US GAAP case with interest paid in CFO, FCFF=CFO+interest×(1−tax rate)−capital expenditure. This restores the after-tax debt financing flow to measure cash available to all capital providers. FCFE=CFO−capital expenditure+net borrowing measures cash for ordinary equity under the stated assumptions. Use consistent interest, tax, lease and capital-expenditure definitions; do not blindly reuse these bridges after reclassifying interest.

A positive FCFE is not automatically distributable or legally available cash. Covenants, restricted cash, repayment schedules, minority interests and necessary future reinvestment can constrain distributions. Management’s label “free cash flow” is not a universal accounting definition; reconstruct the numerator and reconcile to reported cash.

State coverage denominators and their limits

A cash-interest-coverage measure can be defined as (CFO+cash interest+cash taxes)/cash interest when CFO includes those payments. CFO/average total debt is another explicitly defined solvency indicator. Ratios using a small denominator can be unstable, and strong historic coverage does not remove maturity concentration or refinancing risk.

Use sensitivities rather than a universal target: reduce collections, normalize supplier terms and increase maintenance capital expenditure. Check whether cash coverage survives without additional borrowing. Compare peers only after reconciling interest classification, securitization, factoring and supplier-finance effects that may shift reported operating cash.

Bridge operating cash flow to capital providers

Under a stipulated convention in which CFO includes interest paid, CFO 90, cash capital expenditure 50, interest expense 10 and applicable tax rate 25% give FCFF=90+10 ×(1−0.25)−50=47.5. FCFE with net borrowing 5 is 90−50+5=45. The formulas differ because FCFF is before debt financing distributions whereas FCFE retains the effect of debt financing. If CFO classifies interest elsewhere, adjust the bridge rather than adding interest twice.

A positive free-cash-flow year can reflect delayed maintenance, inventory liquidation or stretched supplier payments. Reconcile capital expenditure to asset additions and separate cash from noncash lease additions. Analyze several years and compare reinvestment with the operating plan. Neither a single cash-conversion ratio nor EBITDA establishes sustainable cash available for dividends.

Formula and assumptions

For stated US GAAP bridge: FCFF=CFO+interest(1−T)−capex; FCFE=CFO−capex+net borrowing; CFO margin=CFO/revenue

Cash available to debt and equity

1. Synthetic US GAAP CFO 120 includes cash interest 20 and cash taxes 15; tax rate 25%, capex 70 and net borrowing 10. Revenue is 600 and average debt 300.
2. FCFF=120+20 × 0.75−70=65; FCFE=120−70+10=60. CFO margin=120/600=20%.
3. Defined cash interest coverage=(120+20+15)/20=7.75; CFO/debt=40%. These are historical ratios, not repayment guarantees.

Errors to catch

• Adding back interest when CFO already excludes it.
• Calling cash from asset sales recurring operating cash.

Original knowledge check

Answer every question before checking. Review explanations after submitting; retry starts a new attempt.

Sources and coverage status

These original lessons are drafts. Public outlines are used to check scope; the official learning-outcome text and proprietary question banks are not reproduced here. Follow the source for exam-year requirements and updates.

• Reference · www.sec.gov
• Reference · www.sec.gov