Discretionary Cash Flow
What is “Discretionary Cash Flow”?
Discretionary Cash Flow (DCF) is the post-tax cash flow generated from the core business operations of a company after providing for capital expenditure and working capital (required for its operations). Essentially, discretionary cash flows help investors know how much cash flow a company generates after providing for the major ongoing expenses.
The use of discretionary cash flow is decided by the management and can be available for dividend payouts, paying down debt, or for other uses. It is a useful measure of a company’s financial performance as it shows how much cash a company is generating above its ongoing obligations. Investors like to consider investing in companies with a strong (positive) DCF and it is a key metric to assess the cash flow adequacy of a company.
Key Learning Points
- Discretionary cash flow is the cash that is generated from the core operations of a company less capital expenditure and dividends paid
- The DCF is rather important for the purpose of valuation of a company, assessing its debt repayment capacity, and comparing the financial performance of companies
- If a company has a negative DCF, this indicates that a company is earning less than what it is spending on a periodic basis
Discretionary Cash Flow – Formula
One can obtain the discretionary cash flow of a company by the following formula:
DCF = net income +/- depreciation and amortization and other non-cash items +/- working capital i.e. (changes in the same) – CAPEX – dividends paid
To summarize this formula, DCF is cash generated by the core operations of a company, less capital expenditure, and fewer dividends. S&P defines DCF as free operating cash flows with fewer dividends paid. It is called Free Cash Flow by Fitch Ratings.
Discretionary Cash Flow – Importance and Uses
The DCF is derived from a company’s financial statements and can impact its valuation. It can assist in determining its fair price (for the buyer of a company) and asking price (for sellers).
Analysis of the DCF of a company, enables a lender/bank to know exactly how much cash is available in a company to repay debt. To calculate the debt capacity of a company, lenders/banks/credit analysts will usually compute a company’s DCF. If a company generates a healthy DCF then it would suggest that it should have the capacity to repay additional debt in the future.
Discretionary cash can be used in several valuation processes. It is used in discounted cash flow analysis to value a company or to know what it might be worth, based on the NPV of its cash flows in the future. It is also used in a Leveraged Buyout analysis or model, in order to determine how much debt a company can pay each year.
In order to compare the performance of companies (either across a sector or by geography), analysts can assess their discretionary cash flows. It is useful to analyze whether the DCF is growing or declining each year and at what rate. Analysts will want to know what is driving the increase or decrease in the same – it might be the way the company is run, the stage of the business cycle, or something else which might be specific to the company (or the marketplace).
How DCF is distributed is the responsibility of management. This in turn will impact the business performance, growth prospects, and valuation. For example, if a company generates a relatively high DCF (i.e. strong positive DCF), which is growing at a reasonable or good rate each year, it may need to decide what to spend it on. This might be capital expenditures (perhaps an expansion project or upgrade) to boost long-term growth prospects. Or it could be repaying outstanding debt which would be a priority if the debt costs were considered expensive. Other uses of DCF include spending more on working capital, buying back shares, issuing dividends, or acquiring companies.
Discretionary Cash Flow – An Example
Given below is an example where a company’s DCF is negative, indicating that it earned less than it spent on a periodic basis. If a negative cash flow (DCF) is a trend, it could suggest that the company may be experiencing financial difficulties and it might need to raise debt (or equity) to cover its ongoing spending.
Presented below is the cash flow statement of a company.
The DCF has been calculated and it turns out to be negative -$20. The same can be calculated as Free Operating Cash Flow (FOCF) – Dividends. The FOCF = Operating Cash Flow (taken straight from the cash flow statement) – Capex. It might be noted that in the computations below, the operating cash flow is taken directly from the cash statement.
In summary, discretionary cash flow is a useful metric to see how robust a company’s cash flow generation is relative to its ongoing spending. Companies consistently generating a strong discretionary cash flow would have numerous options to spend this cash: it could be on expanding the business operations, improving the debt ratio, or returning cash to shareholders.
If a company does not generate a positive discretionary cash flow it suggests that the company is spending more on its operations than it is generating. This can be managed in the short term, but management will need to take decisive action if it continues as it erodes the company valuation and may lead to operational issues if it can’t afford to pay for ongoing obligations.