cash flow and company valuation analysis.pdf

International Journal of Arts & Sciences,

CD-ROM. ISSN: 1944-6934 :: 5(7):319337 (2012)

Copyright c 2012 by UniversityPublications.net

CASH FLOW AND COMPANY VALUATION ANALYSIS: PRACTICAL

APPROACH TO INA PLC, THE BIGGEST CROATIAN OIL COMPANY

Tomislav Jeletic

University of Rijeka, Croatia

The goal of this paper is to define and examine the approaches using cash flow for company

valuation. An insight is given to cash flow as a part of the financial statement according to the

International Accounting Standard 7 Cash Flow Statement (IAS 7). The implications of the

theoretical approach and the Discounted Cash Flow (DCF) valuation method are presented

and applied to INA PLC, the biggest Croatian oil company, and the methods pros and cons

are analyzed. Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE) are

defined and employed in the formula of the DCF model. During the application of the DCF,

FCFF and FCFE methods, cash flow statement according to IAS 7 is used as source of model

variables. Other methods are presented and compared to the DCF: in particular the Economic

Profit Model and the Adjusted Present Value. Static ratios using cash flow are shown as tools

for valuation. An overview of possible cash flow statements manipulation methods is given as

a warning for a potential distortion of model results. The outlined theoretical and practical

implications of the application of cash flow models in Croatia can be used to improve their

understanding and usage and to predict their potential future development.

Keywords: Cash flow statement, Company valuation, DCF, IAS 7.

Introduction

The center of economic life of every economy is a company or firm. According to this statement,

the community interest for the corporation is understanable. Financial statements are the source

of information for all the interested parties and serve as a basis for valuation of the company.

Internal and external users of financial statements use them as a basis for decision making and

through the analysis they create a picture not only of the financial condition of enterprises, but

the overall business. In the first part of te paper the objects of the research are defined and the

research hypotheses are set. Furthermore, the purpose and research methods are outlined. The

second part (Financial Reporting Standards) provides an overview of related financial reporting

statements and standards. The third part (Cash Flow Statement) provides the framework for

preparing The Cash Flow Statement. Furthermore two diferent methods are described and the the

basic elements are outlined. In the fourth part (Cash Flow And Firm Value) The Discounted

Cash Flow as valuation method is described and The Free Cash Flow is defined. All the defined

terms listed above are used to detect the value of INA PLC, the biggest Croation oil company,

and a system of indicators based on Cash Flow are listed. In the fifth part (Cash Flow

Manipulation) the statement manipulation practices that may occur and distort the data are

elaborated. In the sixth part (The Outlook Of The Contemporary Accounting Practices and

Advanced Valuation Models in Croatia), the author gives his opinion on the future development

and usage of advanced valuation models in Croatia.

319

320 Tomislav Jeletic

Object, Methodology, Research Hypothesis and Purpose

There is a wide range of users that base their decisions on data obtained from financial

statements. Investors make decisions about buying or selling stocks or shares based on the

financial statements. Banks make decisions about approving loans based on financial statements,

and the company management uses financial statements as an instrument for governance. It is

therefore clear that the accuracy of fiancial statements is crucial for makig right decisions.

However, there is a beliff that financial reports are more reliable than others. The term reliability

is primarily understood as the possibility of manipulation in broadly defined boundaries of

international standards. In particular, it relates to revenue and profit as a category of financial

statements. The major authorities in the field of accounting and investment cobfirm that, among

financial statements, the cash flow is the most reliable cathegory.

In the paper an overview of financial statements is given, and a special emphasis is placed

on the Cash Flow Statement, as the most reliable and underutilized in Croatia. Valuation

methods using Free Cash Flow and the possibilites for manupulation within the statement are

illustrated. The object of the research are: to define the basic guidelines of cash flow and the

Cash Flow Statement, to display the methods of valuation using free cash flow and indicate the

possibilites for manipulation within the Cash Flow Statement.

By defining the cash flow and the Cash Flow Statement it is possible to understand the

company's business, to define the fair value of the firm and to recognize the existing weaknesses.

The main hypothesis implies several additional hypotheses as follows:

improving the knowledge of the International Financial Reporting Standards dealing with

cash flow it is possible to provide a better basis for decision making

free cash flow and its discounting provide reliable data on the present value of the company.

the existence of possibilities for manipulation: the knowledge of the week spots allow us to

avoid unwanted loss.

The purpose of this paper is to provide a basis for understanding the Cash Flow Statements and

to apply the existing theories on the Croatian market and thus contribute to the implementation

of contemporary accounting issues.

Using appropriate methods of analysis and synthesis, industion and deduction, comparative

and descriptive methods and methods of compilation, the author will try to answer the following

questions:

What are the financial statements?

What are the basic features of the cash flow statement?

What is free cash flow and how can it be used?

How is possible to estimate the value of a company using cash flow?

Where the shenanigans may ocure in the cash flow statement?

Financial Reporting Standards: General Remarks

Financial statements are by far the most important tool for the parties interested in analysing a

business (users of financial statements) or having an insight into the company's business. From

the data provided in financial statements investors and other users can form a whole range of

useful information for decision making. The final product of the financial accounting process is a

Cash Flow and Company Valuation Analysis... 321

set of reports called financial statements. The Croatian Accounting Act clearly states that "accounting tasks are collecting and processing data based on accounting documents, preparation, bookkeeping and compilation of annual financial statements ..." The preparation of

financial statements consists of a number of actions that have the purpose to present a final amount of assets, liabilities and equity on the balance sheet at the end of the business year and the final amounts of revenue and expense in profit or loss for the year. It is evident that the

financial statements are one of the basic accounting tasks. A set of financial statements consists of: Statement of Financial Postition (also referred to as Balance Sheet); Statement of Comprehensive Income (also referred to as Profit and Loss Statement);

Statement of Changes in Equity; Statement of Cash Flow; Notes (including disclosure of significant accounting policies and other explanatory notes).

Annual financial statements must give a true and fair insight into the companys financial position and performance. The entrepreneur is required to prepare an annual report cosisting of an objective view of the development and results of operations, their location, a description of

the principal risks and uncertainties faced, as well as information about the environment and employees (Croatian Accountig Act). From the standpoint of an investor who seeks to determine the value of a business, it is interesting to focus on the Croatian Accounting Act it points out that

the annual report must include all significant events after the end of the year, the likely future development of the firm, research and development activities, information about purchase of the shares, the existence of a subsidiary company, the financial instruments used (if this is relevant

for assessing the financial position and business performance), objectives and policies of the company related to financial risk management, the policy of protection of each major type of forecasted transaction for which protection is used, the exposure of the firm to price risk, the

credit risk, the liquidity risk and the cash flow risk. Furthermore the Annual Reports of large companies and businesses whose shares or debt securities are listed on an organized securities market shall contain the corporate governance rules that are used (Croatian Accounting Act).

For Publicly Listed Companies there are additional legal provisions that define the limits

and the course of ratification of financial statements by all the management bodies. (Gulin, 2006:16). Article 13 of the Accounting Act points out that: "... large firms and firms whose

shares or debt securities are listed or are in the process of preparation for listing on an organized securities market shall prepare and present annual financial statements using International Financial Reporting Standards." International Financial Reporting Standards include the

International Accounting Standards (IAS), amendments and related interpretations and International financial Reporting Standards (IFRS), amendments and related interpretations.

According to that, the results of this research will not only be applicable to companies listed on

regulated markets but also to all big entites1. The aim of the International Accounting Standard 1 is to prescribe the basis for presentation

of the basic financial statements: The Statement of Financial Position (also referred to as Balance

Sheet), The Statement of Comprehensive Income (also referred to as Profit and Loss statement),

1 According to the Accounting Act (Official Gazette 109/2007) an enterprise is considered to be large if it exceeds

two of the three following criteria: total assets of HRK 130 mil (US$ 22 mil), revenue of HRK 260 mil. (US$ 44

mil.), the average number of employees during the financial year 250


The Statement of Changes in Equity and Notes, including disclosure of significant accounting

policies and other explanatory notes. Althought Cash Flow is one of the five financial statements,

it is elaborated in a separated standard called IAS 7 Cash Flow. Furthremore IAS 1 encourages

companies to publish financial management reviews which should describe and explain: the

main factors and influences on performance, the financial situation, funding sources, policies for

risk management and uncertainties as well as strength and resources whose value can not be seen

from the Balance Sheet.

The Statement of Financial Position

The Statement of Financial Position or Balance Sheet is the current value statement of assets and

liabilities of the business entity on a specific day (Mrsa, 2007a: 41). Being the "report of the

financial situation", it allows users (like shareholders or creditors) to clearly see the financial

situation or position of the company in a specific moment. This Statement is a double image of

the same value: from one side the value of the companys assets is shown and on the other side

the source of funding is shown (liabilities).

According to IAS 1 companies should separately present current and non-current assets and

current and non-current liabilities. IAS 1 does not proscribe a strict form for reports, so the

company chooses whether it will be under the principle of increasing or declining liquidity. A

minimum of information is given, as follows:

property, plant and equipment

investment property

intangible assets

financial assets (excluding amounts shown under (e), (h), and (i))

investments accounted for using the equity method

biological assets

inventories

trade and other receivables

cash and cash equivalents

assets held for sale

trade and other payables

provisions

financial liabilities (excluding amounts shown under (k) and (l)) (n) liabilities and assets for

current tax, as defined in IAS 12

deferred tax liabilities and deferred tax assets, as defined in IAS 12

liabilities included in disposal groups

non-controlling interests, presented within equity and

issued capital and reserves attributable to owners of the parent

Furthermore IAS 1 requires disclosure for each class of share capital and a description of the

nature and purpose of each reserve in the form of equity. It is evident that the purpose of The

Balance Sheet in not only to show assets, liabilities and capital but also to provide a good base to

start the analysis. Because of the narowness of infromation, the usage of Notes that describe the

details of The Balance Sheet are crutial.


Statement of Comprehensive Income (Also Referred to as Profit and Loss Statement)

This report provides users with information about the success of the company for each

accounting period. The Statement of Comprehensive Income includes income, expenses and

operating result as a difference of income and expenditure between the Balance Sheet date.

Revenues are the consequences of an increase in assets or decrease of liabilities. They are

divided into regular one (revenues from sales of products, services and financial income) and

other extraordinary income or the ones that do not arise from ordinary activities. Reduction of

assets or increase of liabilities result in expenses. They can be regular (costs contained in the

goods sold or services and financial expenses) or extraordinary expenses that are not the result of

performing their regular activities. Financial results are the consequence of confronting revenues

and expenditures (Gulin, 2006: 725). The standards define the minimum number of positions that

should be disclosed:

revenue,

finance costs,

share of the profit or loss of associates and joint ventures accounted for using the equity

method,

tax expense,

a single amount comprising the total of (i) the post-tax profit or loss of discontinued

operations and (ii) the post-tax gain or loss recognised on the disposal of the assets or

disposal group(s) constituting the discontinued operation,

profit or loss,

each component of other comprehensive income classified by nature,

share of the other comprehensive income of associates and joint ventures accounted for using

the equity method,

total comprehensive income.

The analysis of income can create a picture of the quality of operations in the composed profit

and loss account period. The Balance Sheet is useful as a supplement to the information provided

by the profit and loss account. However, the data in the Notes, regarding the profit and loss

account, have to be analysed too.

Statement of Changes in Equity

In accordance with IAS 1, a company should present a Statement of Changes in Equity, in the

following order:

profit or loss for the period,

each item of income and expense,

total income and expense,

the effect of changes in accounting policies.

Furthermore, an entity shall disclose:

the amount of capital transactions with owners, showing separately distributions to owners;


retained earnings at the beginning of the year and the Balance Sheet date and changes over

time;

adjustments to the carrying amount of each category entered in equity and each reserve at the

beginning and end of the period, showing separately each change.

It is obvious that the report of changes in equity shows all changes related to equity during the

reporting period. The importance of this report comes from the importance of equity for the

stability of the business. Changes in equity directly affect the stability of funding, and thus the

business.

Notes

The Notes inform financial statement users about accounting policies, changes to them and all

the information that would burden other reports. Notes provide a detailed insight in all the

positions of the other statements. IAS 1 under item 21 defines the accounting policies as a sum of

principles, bases, conventions and practices adopted by an enterprise in preparing and presenting

financial statements. The accounting policies therefore include all accounting assumptions,

principles, methods, procedures and rules used by an entrepreneur in order to formulate the

financial statements in their final form (Gulin, 2006: 745). The Notes contain information such

as information on the size and structure of inventories and fixed assets, information about the

overall business indicators, plans related to compensation to the management, amount of rent,

possible transactions (Anthony, Reece, 2004: 305), and may contain the following (Mrsa,

2007b):

a statement that the reports are consistent with the requirements of IFRS,

review of significant accounting policies

additional information for items published in the basic financial statements, in order to

present them in the basic financial statements;

other liabilities which include: uncertain obligations, uncertain assets and provisions, the

non-financial liabilities, the amount of dividends voted before the publication of financial

statements, the cumulative amount of dividends on preferred stock which are not recognized

in the accounting period.

The importance of the Notes to the financial statements is unquestionable for their full

understanding and therefore of the business. Furthermore, it is necessary for a full company

analysis.

The Cash Flow Statement: Operating, Investing and Financing Activities

The Cash Flow Statement is elaborated in a separate IAS, the IAS 7, while all the other

statements are included in IAS 1. IAS 7 defines the objectives, scope, use of information, data

definitions and gives the manner of presentation, the demarcation of the various activities and

other provisions that create the framework for the preparation of Cash Flow Statements. Its aim

is to explaned at the beginning of IAS 7, and that is to help users of financial statements to

provide a basis for assessing the entity's ability to generate cash and cash equivalents, as well as

the needs for cash flows of the subject. The above coincides with the opinion of many authors


who find that the Statement of Cash Flow is one of the best sources of information for decision

making for investitors (Mulford, Comiskey, 2005: 1). IAS 7 states that the Statement of Cash

Flow presents the cash flows of businesses during a specific period and in particular for:

operating or business activity,

investing activities,

financing activities.

Operating activities are the main revenue generator. In other words, they are focused on

producing and selling products, goods and services. Investing activities are the acquisition and

disposal of fixed assets and other investments not included in cash equivalents. Investing

activities include investments in securities or other types of long term investments. These

activities include the sale of securities and the sale of long term investments. Financing activities

are activities that result in changing the size and composition of equity and borrowings of the

entity. They include receiving money from the owners (share issue) and payment to owners of

invested assets (dividends). Financing activities include borrowing taking and debt return (this

does not include interest payments: they are involved in business activities). The division of cash

flow in three activities creates an image of three business segments, and thus identifies

companies able to generate money, finds the level of investment, identifies the cash outflows for

debt repayment. Through these areas the strength of business and the businesses power to

generate money is shown (Gulin, 2006: 728-729).

IAS 7 proposes the composition of the Cash Flow Statements and point out that the

company presents business, investing and financing activities in the best suitable way.

Cash flows from operating activities are primarily derived from the main production

activities of the entity that generate revenue. Therefore, they generally arise from transactions

and other events that are included in determinating profit or loss. Examples of cash flows from

operating activities are:

cash receipts from sales of goods and services;

cash receipts from royalties, fees, commissions and other income;

cash payments to suppliers of products and services;

cash payments to and on behalf of employees;

cash receipts and cash payments from an insurance entity for premiums and claims and other

benefits from the insurance policy;

cash payments or refunds of income taxes unless they can be specifically related to financial

and investment activities;

cash receipts and payments under contracts that are used to dealing or trading purposes.

The analysis of information obtained from observing the cash flow from operating activities

creates a picture of the opportunities for the company to generate cash flow from its core

business. This is the most significant cash flow, and the "healthiest" source of capital needed for

development and growth in enterprise value.

IAS 7 states that it is important to disclose separately cash flow from investing activities,

since they show the size of investment in resources that are intended to generate future income

and cash flow:


cash payments to acquire real estates, plants and equipment, intangible assets and other long

term assets. These payments include those relating to the capitalization of development costs

and construction of property, plant and equipment developed within the company;

cash receipts from sales of property, plant, equipment, and other long term investments;

cash paid for buying equity or debt instruments of other entities and interests in joint ventures

(other than payments based on instruments that are considered to be cash equivalents or held

for dealing or trading purposes);

cash receipts from sales of equity or debt instruments of other entities and interests in joint

ventures (other than receipts basis of instruments that are considered to be cash equivalents

or held for business or commercial purposes);

cash advances and loans made to other parties (other than advances and loans made by

financial institutions);

cash receipts from the repayment of advances and loans made to third parties (other than

advances and loans from financial institutions);

cash payments under the contract, futures, forward, options and swaps, except where such

contracts are held for dealing or trading purposes or payments are classified as financing

activities;

cash receipts under the contract, futures, forward, options and swaps, except where such

contracts are held for dealing or trading purposes.

The last two point out advanced financial instruments and it is important to mention them

specifically when the inevitable expansion of the Croatian businesses abroad is expected.

Particularly interesting is the fact that IAS 7 states that "when a contract is accounted for as a

protection of the identified position, the cash flow of the contract is classified in the same

manner as the cash flow of the position that is hedged." Losses due to foreign exchange losses

affecting some sectors of the Croatian economy (eg shipbuilding) should serve as a warning to

all subjects and an incentive to protect against currency risk, which is common in the world and

is a practice described even in IAS 7.

By analysing investment activities it is possible to see what are the "requirements" for future

business investment. In other words, it is possible to see the amount of investment in an

enterprise that guarantees the company's ability to generate future cash flow. The amount of

investment activities is especially useful when compared with other companies in the same

branches.

The separate disclosure of cash flows arising from financing activities is important because

it benefits those who provide capital for the future development of the entity. Examples of cash

flows from financing activities are:

cash receipts from issuing shares or other equity instruments;

cash payments to owners to acquire or redeem shares of the entity;

cash receipts from issuing loans, notes, bonds, mortgages and other short-term

or long-term borrowings;

repayment of money borrowed amount.

The analysis of cash flow from financing activities and their comparison with cash flow from

operating and investing activities is useful for seing the state of external financing and the

receipts and expenditures for all forms of financing. By comparing the cash flow from financing

activities to cash flow from financing activities of competing firms, using data from the Balance


Sheet and the various indicators, it is possible to create a complete picture of the sources of

corporate financing and the dependence on debt capital, sources of stabile financing and equity

prices.

Methods for Composing the Cash Flow Statement: Direct and Indirect Methods

There are two methods by which IAS approves the preparation of the Cash Flow Statements: the

direct and indirect method. When the direct method is applied major classes of gross cash

receipts and gross cash payments are applied. IAS 7 encourages entities to report cash flows

from operating activities using the direct method. The direct method provides information that

may be useful in estimating the future cash flow which are not available to the indirect method.

The direct method include information about major classes of gross cash receipts and gross cash

payments may be obtained in the following ways:

from the accounting records of the subjects; or

by adjusting sales, cost of sales (with financial institutions, interest and similar income and

interest expense and similar charges) and other items in the income statement for:

changes during the period in the field of inventories and receivables and payables;

other non-cash items;

other items whose cash effects are investing or financing cash flows.

Using the direct method, the company shows the main types of cash receipts and expenses from

operations, after which the sum or cash flow is given. Companies that choose this method, in the

report relating to the business, have to show at least the following types of cash receipts and cash

expenses:

cash received from customers, including other cash receipts, such as advances, royalties, etc.;

cash receipts from interest and dividends;

other cash receipts from operating activities;

expenditures to employees, suppliers of raw materials, goods and services including

insurance and home advertising, etc.;

cash paid for interest;

cash paid for taxes;

other cash flow-based business activities.

For all large enterprises it is recommended to use the indirect method.

The indirect method adjusts profit or loss for the effects: of transactions of non-cash nature,

of any deferrals or billing amounts past or future operating cash receipts or payments, and of the

items of income or expense related to investing or financing cash flows.

According to the indirect method, the net cash flow from operating activities is determined by

adjusting the profit or loss for the effects of:

changes during the period in inventories and receivables to inventory and receivables and

payables;


non-cash items such as depreciation, provisions, deferred taxes, unrealized positive and

negative exchange rate differences, undistributed receipts associated companies and minority

interests;

all other items for which the cash effects are investing or financing cash flow.

The indirect method of cash flow from operating activities is determined indirectly by adjusting

the net profit of the company with effect from:

a) changes such as increase or decrease in inventories, receivables and payables;

b) depreciation of fixed assets and revenues and expenses from sale of fixed assets (relating

to investment activities) as well as revenues and expenditures of the debt write-offs (related to

financial activities).

Often the process of cleaning or transforming of net profit to cash flow from operating

activities for the indirect method performed according to U.S. GAAP2. The process is shown in

the Figure below (Figure 13).

Figure 1. Calculation of the business cash flow from a pure profit.

Includes accounts payable, liabilities for wages (accrued wages), interest payable (accrued interest expenses), liabilities for

taxes. Do not include liability notes payable or liquid portion of long-term debt.

Cash Flow, Company Value and Free Cash Flow

In the field of valuation of companies there is not a great consensus of financial professioanls

and investors for the most appropriate method to use. In this chapter the emphasis will be placed

on the DCF method and it will be applied to INA PLC. Furthermore, a comparison with other

methods will be given. Before dealing with the DCF method in detail, it is necessary to define

Free Cash Flow. After the definition the DCF method will be described and applied to INA PLC.

Free Cash Flow in recent times is gaining importance from the point of view of investors.

This is supported by the fact that an increasing number of companies that operate in the most

developed securities market (like the American one) regularly publish information on Free Cash

Flow in their reports (Mulford, Comiskey, 1997: 345). According to IAS 7 "The separate

disclosure of cash flows that represent increases of capacity and cash flows required to maintain

2 There is an accordance between U.S. GAAP and IAS 7. 3 Taken from: Anthony, Reece (2004: 255).

Clean

gain +

Depreciation expense

Increase in deferred

taxes

Decrease in receivables

Decrease in inventories

Decrease in prepaid

expenses

The incrase in liabilities

Loss from sale

-

Decrease in deferred taxes

Increase in inventories

Increase in prepaid

expenses

Decrease of liabilities

Gain from sale

Net cash

flow

from

operating

activities

=


operating capacity is useful because it allows users to determine whether the company invested

in the proper maintenance of its operating capacity." (Mulford, Comiskey, 1997: 345).

According to this view there are various definitions of Free Cash Flow. One of them is the Free

Cash Flow that represents the amount available for capital requirements while maintaining

productivity levels unchangend. Mulford and Comiskey (1997: 386) further divide Free Cash

Flow to Free Cash Flow for the company (the FCFF: Free Cash Flow to Firm) and Free Cash

Flow to owners of ordinary shares (the FCFE: Free Cash Flow to Equity).

According to the authors Free Cash Flow for the company consists of cash flow from

operating activities before interest but after investment expenses4. In accordance this definition is

the definition of Copeland, Koller and Murrina. They state that Free Cash Flow is equal to the

sum of profit after taxes plus non-cash expenses and net investment in working capital, property,

plant and equipment and other property (Copeland et al., 2000: 134). From their point of view

the definition that matches best the DCF model is the one that expresses the cash flow that the

company generates from its business, which is available to all capital owners (equity and debt

capital). For the purpose of this study the author will use a simplified method, less complex

method than the one used by Copeland et al. The simplier DCF method for FCFF and FCFE is

the one used by Demodarna5.

Free Cash Flow and INA Oil Industry PLC.

The following assumptions are relevant for the calculation: cash flow from operations will be

equal to cash flow from operating activities, capital expenditures will be equal to cash flow from

investing activities and interest will be equal to the interest on short-term and long-term loans,

tax relief for interest will be abstracted, just like other adjustments that would be required to

obtain a more realistic Free Cash Flow. The calculation of Free Cash Flow for the INA PLC.

follows6 in Figure 2.

2011. 2010. 2009. 2008.

CASH FROM OPERATIONS 3.534 1.563 2.960

2.629

- CASH FROM INVESTMENT 1.591 2.809 4.490 4.354

FREE CASH FLOW FOR OWNERS OF COMON SHARES 1.943 -1.246 -1.530 -1.725

+ INTERESTS PAID FOR LONG TERM LOANS 704 786 399 411

FREE CASH FLOW TO FIRM 2.647 -460 -1.131 -1.314

Figure 2. The calculation of Free Cash Flow for the oil industry INA PLC. (amounts given in millions kunas7).

4 www.investopedia.com/terms/f/freecashflow.asp (29.2.2008), www.investopedia.com/terms/f

/freecashflowtoequity.asp, (29.1.2008), www.investopedia.com/terms/f/freecashflowfirm.asp, (29.1.2008),

Copeland et al..: Valuation Measuring and Managing the Value of Companies, McKinsey & Company Inc., New

York, 2000: 134. 5 See: Fcff.pdf i fcfe.pdf, pages.stern.nyu.edu/~adamodar/New_Home_Page /valuation/val.htm#ch2 (27.1.2008). 6 The calculation of Figures 2 and 3 are made according to the financial reports published on www.zse.hr,

(28.2.2008). 7 The kuna is the Croatian currency. One (1) USD is around 5.8-5.9 kunas.


It is evident that Free Cash Flow is negative (years 2010, 2009, 2088). The reason for this is

that it is taken a more realistic measure of capital expenditure, which is expenditure for investing

activities (which are for future business growth) instead of estimates of capital expenditure on

depreciation (Mulford, Comiskey, 1997: 11). In Figure 3. it is shown the Free Cash Flow

calculated using depreciation as a mesure of investment activities.

2011. 2010. 2009. 2008.

CASH FROM OPERATIONS 3.534 1.563 2.960

2.629

- CASH FROM INVESTMENT 2.640 1.750 1.507 1.371

FREE CASH FLOW FOR OWNERS OF COMMON SHARES 894 -187 1.453 1.258

+ INVESTMENTS PAID FOR LONG TERM LOANS 704 786 399 411

FREE CASH FLOW TO FIRM 1.598 599 1.852 1.669

Figure 3. The calculation of Free Cash Flow for the oil industry INA PLC. with an estimated investment

on the basis of depreciation (amounts in millions of kunas).

There is a big difference that distorts the information. Certainly the first calculation in Figure 2.

thorough and reliable, and provides information that shows the actual situation within the INA

PLC.

Disconted Cash Flow

As stated previously in this paper, the Discounted Cash Flow (DCF) method is uset to calculate

FCFF and FCFE. The following formula is the general formula for DCF (Value of the Company)

(Orsag, 1997: 197.):

=

+=

n

t

t

t

rVALUE

CF

1 )1( (1)

Where:

t time period

ncompany's timelife

CF cash flow in the period of t

r discont rate (cash flow valuation risk included)

It is evident from the above formula that, according to this method, the value of the company is

equal to the sum of Discounted Cash Flows for all the years the calculation is performed. It t is

recommended to take the price of the opportunity cost of invested capital as the value of r.

According to the presented formula, the DCF method will be elaborated in order to calculate the

FCFF and FCFE.


The companny value is calculated as follows8:

)(

1

ngWACC

FCFFValue

= (2)

Where:

FCFF1 the expected FCFF for the next year

WACC waged avarage capital cost

gn rate od FCFF growth (tending to infinity)

Model assumption:

growth rates in the model should be reasonable in relation to the growth of the economy;

ratio of capital expenditures and depreciation is a constant with a constant growth rate.

WACC is calculated using the formula as follows9:

)1(Re TcRdV

D

V

EWACC += (3)

Where:

WACC the weighted avarage capital cost

Re cost of equity

Rd cost of dept

E equity value

D company's dept value

V E+D

E/V percentage of financing from equity

D/V percentage of financing from dept

Tc tax rete

WACC serves as the discount rate that complies with the definition of DCF and expresses the

opportunity cost of all capital sources according to their part in the companys total capital

(Copeland et al., 2000: 134). Using the formula above the companys present value of cash flow

is calculated under the assumption of infinite and continuous business growth. The specified

value is used when determing the value of the firm.

The present value of the company (PV of FCFE) is calculated using the formula10

:

8 See: fcff.pdf, Copeland (131), www.investopedia.com/university/dcf/, (27.1.2008); Copeland et al. (2000: 131);

Mulford, Comiskey (1997: 359). 9 See: www.investopedia.com/terms/w/wacc.asp, (1.2.2008). 10See: Fcff.pdf, pages.stern.nyu.edu/~adamodar/New_Home_Page/valuation/val.htm#ch2, (27.1.2008); Mulford,

Comiskey (1997: 360).


ngr

FCFEP

=1

0 (4)

Where:

Po present value of the company

FCFE1 expected Free Cash Flow for Equity in the next year

r company's equity cost

gn rate of company's FCFE growth (tending to infinity)

The model can be used if the comany is stable if capital investments are not bigger than

amortisation, shares' beta is close to 1, the debt is stabile and dividends are not significant. DCF

for FCFE is not as accurate as DCF for FCFF. In praxis it is harder to calculate the DCF using

FCFE. The calculation is used for determing the company's value.

DCF-based fundamental indicators are certainly less tendent to volatility. DCF is

particularly advantageous if the investor buys a share for a longer investment period (as does W.

Buffet). One of the advantages is certainly the fact that the investor should be thoroughly

familiar with the operations of enterprises because in this way he stands face to face with the

assessment of the growth of the company. A disadvantage that can be mentioned is his need for

more input data than other models. Huge amounts of data not only creates the vastness, but also

opens up the space for manipulation which aims to provide distorted information. Furthermore

there is no guarantee that something will be overevaluated or undervalued. It may happen that

the model shows that the entire market is underevaluated, which can be a particular problem for

the portfolio managers and analysts. The limitation is that the model can be used only for

companies: with positive current cash flow, with a high probability of estimating of future cash

flow and with a reliable indication of risk to which the future Free Cash Flows could be

discounted. The model is mostly suitable for investors who have long targeted investment times

(which will allow the market to correct the errors in estimating) or sre able to provide a catalyst

that will bring the price values to the adequate value or a potential buyer of the entire company11

.

Other Valuation Methods

The following is an overview of several methods of valuations that do not belong to the widely

known ones. The model of Economic Profit is a commonly used model in which the value of the

company is equal to the invested capital plus a premium that represents the present value of the

value that is created each year. The concept of economic profit is based on the theory of Alfred

Marshall formed in the 1890. Marshall's theory states that the value created by the company

through any period of time must take into account not only the accounting cost but also the

opportunity cost of capital invested in the company.

The advantage of this model compared to the DCF is that economic profits can be used to

understand the operations of any company in a single year, which is not the case of Free Cash

Flow. For example, the management of the company can increase the Free Cash Flow by

postponing planned investments for the future. Thus, Free Cash Flow is subject to discretionary

management measures. So this model mesures the performance in a single period and is more

reliable (Copeland et al., 2000: 178).

11 See: Approach.pdf, pages.stern.nyu.edu/~adamodar/, (31.1.2008).


Another model is the Adjusted Present Value model that is similar to the DCF model. The

DCF and APV discount Free Cash Flow in order to obtain the value of the company. This model

subtracts the debt value from the companys value and reaches the companys present value. The

difference between DCF and APV-a is that the APV model separates the value of cash flow from

the operations on two values: the value of the operation if the company would only be financed

from its own resources and the benefit of the tax shelter because of financing through debt. The

APV concept is used to indicate the impact of taxes on the assessment of the future value of the

company. The contribution of this model is reduced after findings that taxes do not have a crucial

role in determining the price of the shares of the company (Copeland et al., 2000: 180). There

may be variations of the DCF model:

use real instead of nominal cash flows and discount rates;

discounted cash flow before taxes, instead of the cash flow after taxes;

prediction using a variety of formulas instead of explicitly discounting the estimated cash

flow.

The last variation of the DCF is not advisable for use nor reliable and it would be advisable to

forecast cash flow based on the circumstances of each enterprise, which is estimated separately

(Copeland et al., 2000: 183).

The DCF model applied on INA PLC

Before doing the calculation of the DCF, the Free Cash Flow has to be calculated first. For the

calculation of the FCF, the last availible data is used (Figure 4):

2011. 2012. (estimate)

CASH FLOW FROM OPERATING ACTIVITIES 3.534 3.816

- CASH FLOW FROM INVESTING ACTIVITIES 1.591 1.591

FREE CASH FLOW FOR OWNERS OF COMON SHARES 1.943 2.225

+ INTERESTS PAID FOR LONG TERM LOANS 704 704

FREE CASH FLOW TO COMPANY 2.647 2.929

Figure 4. Calculation of Free Cash Flow for INA PLC. for the year 2011 and the estimation for 201212

(values in millions of kunas).

The Cash Flow for 2011 is positive as a result of the investments made in the previous years.

The estimation of data for the 2012 is made using historical trands and expectations of the

author. Investing activities are estimated to be the same as in 2011.

Using data from Figure 4, FCFF, FCFE and WACC are calculated. The cost of INA's own

capital is estimated to be 5,66% (according to market trends in Croatia), the cost for loans is

estimated to be 11%, the percentage of INA's capital is 57%. According to formula (3) WACC is

7,59. The growth of Free Cash Flow is expected to be 4,5%.

12 Source: INA PLC. Financial reports at the Zagreb Stock Exchange.


789.94045,00759,0

2.929

)(

1=

=

=

ngWACC

FCFFValue (5)

The value for the firm according to DCF is 94.789 million kunas. In the following

calculation (6) the value of the company for equity owners is calculated according to the formula

(4) and data are taken from Figure 4. The r is equal to WACC and gn is equal to the data used in

(5).

006.72045,00759,0

225.210 =

=

=

ngr

FCFEP (6)

The present value of the company is 72.006 milion kunas. Because of the abstraction of some

values this value is not accurate but can be a clear ilustration of the valuation model.

The System of Ratios Using Cash Flow as Data Source

In almost all textbooks of finance and accounting indicators are mentioned, but it is almost

impossible to find them among the indicators that are based on the Cash Flow Statement. The

following ratios that will be presented are based on data that can be found in the Statement of

Cash Flow (Mills, 1991). Indicators of cash flow for the assessment of liquidity:

Interests coverage ratio = Cash flow from operations

Expenditure for interests

Liabilities coverage ratio = Cash flow from operations dividends paid

Expenditure for interests

Coverage of dividends from

common shares

=

Cash flow from operations- dividends for preferred

shares

Cash flow for dividends from common share

Coverage for the sum of

dividends =

Cash flow from operations

Cahs flow for the sum of dividends

Indicators of capital quality:

Quality of realization = Cash income from realization

Realization (sales)

Quality of profit = Cash flow from operation

Profit from regular activities

Quality of profit = Cash flow from operations before interest and tax

Profit before interests, tax and amortization

Indicators of capital expenditure :


Indicator of capital assets

buying =

Cash flow from operations cash flow for dividends

Cash expenditure for capital assets

Indicator of investments = Cash flow for investment activities

Cash flow from financial activities

Indicator of financing = Cash flow from investment activities

Cash flow from operations and financial activities

Indicators of Cash Flow return:

Cash flow per share = Cash flow from operations cash expense for preferred stocks

Weighted average of preferred shares

Cash return per invested

assets =

Cash flow from operations before interests and tax

Average assets

Return on liabilities and

capital =


Avarage of liabilities and capital

Return on capital =


Avarage capital

It should be noted that empirical data show that in developed countries the mesure of a

"healthy" company is the ratio of cash flow from operating activities to current liabilites of at

least 40% and a ratio of cash flow from operationg activities to liabilities of at least 20% . For all

these ratios there is a rule that is comparable only with companies within the same branch or in

comparison with the average branch. It is certainly useful for observing the dynamics of the

observed ratios over time and for making comparisons with companies from the same branch.

The system parameters without the use of other valuation methods is useless, but if

complemented with other methods, it can be very useful when valuating the signs of the

company and thus determing the enterprise value.

Cash Flow Manipulation

In developed financial markets, investors value particularly the ability of firms to generate large

amounts of "cash" from their business (www.businessweek.com/magazine/content/02_28/

b3791114.htm, (1.2.2008.). Due to the high expectations of the market, frauds occur

(www.winninginvesting.com/spot_red_flags_easier.htm, 1.2.2008). The reasons for

manipulation are: the impact on share price, the impact on the ability to borrow, and to

compensate employees13

. One of the main reasons for the possibility of fraud is the flexibility of

standards and there are cases of fraud that go beyond the permissible standards. Some of the

most common opportunities for fraud is the classification of cash flow as cash flow from

operating activities altought it would normally be an investment or financial activity (Mulford,

Comiskey, 1997: 81 - 121). Some potential fraud are: (www.investopedia.com/articles/basics/

05/062405.asp, 2.2.2008):

13 Cf. Mulford, Comiskey, 1997: 33; www.investopedia.com/articles/basics/05/062405 (2.2.2008).


profits from trading in securities classified as cash flow from operating activities;

questionable capitalization of expenses (eg for software development);

securitization of receivables (although it is not applied in Croatia).

One way to "verify" cash flow from operating activities is to compare it with the net profit

over a longer period of time (www.winninginvesting.com/spot_red_flags_easier.htm, 1.2.2008).

Because of its simplicity, this method is not sufficient. Mulford and Comiskey (1997: 241)

developed complex methods to adjusted cash flow from operating activities and thus obtain more

reliable data. The authors found some differences between the reported cash flow and the

corrected one in a 3 years period of time. In some companies the differences were small, while in

some they were significant. All the companies were taken form the S&P 100 index. The Cash

Flow Statement is the most reliable Financial Statement, however certain caution is needed.

Perspective Of The Contemporary Accounting Practice And Advanced Valuation Models

In Croatia

There are few trends that will have impact on the future development of the accounting and

company evaluation practice in Croatia. One of them is certainly the fact that Croatia will

become a member of the European Union in 2013. In 2008 the actual Accountig Act has been

voted. A signs of the development of the Croatian accounting practices is the article which

stipulates that from the date of Croatian accession to the EU the IFRS and interpretations

published in the Official Journal of the EU are to be applied to the Croatian accounting practice.

Another significant trend is a restrictive monetary policy of the Croatian National Bank14

, which

led to the fact that many companies raise capital through the capital market. Their number is still

realtively small but its growth is expected as the financial crisis slowns down. However in the

near future a larger number of shares, investors and more mature market is expected. As the

market matures more and more companies will understand the importance of transparency and

publication of detailed financial data. The consequence of such a trand is the fact that analyst

will have enough data for using more advanced models. More technical and fundamental

analysis expected as well as the modification of the worlds famous models to the small

emerging market economy.

It is posible to expect that the owners themselves will insist on a realistic presentation and

consistent application of standards, because in this way they will receive the highest quality of

information for decisions making. In conclusion the importance of IFRS aplication will grow

with the simultaneus growth of financial reports understanding. Therefore Cash Flow and

evaluation models using cash flow are the hidden star of the future.

Conclusion

The aim of this study was to apply some parts of the world's current theories and models on the

Croatian capital market. Emphasis is placed on two accounting areas in order to give an

overview of the financial statements which give a "health chack-up" of each company (and in

particular the Statement of Cash Flow as a source of important information) and valuation of the

company.

14 HNB Hrvatska Narodna Banka.


The perspective of Cash Flow usage as a valuation tool is clear. The Croatian market is still

evolving and more advanced models of valuation (such as the Cash Flow models) are waiting for

thair chance. As the market evolves, the financial reports are becoming more and more accurate

and that is the trigger of the chance that more advanced models are waiting for. It is hard to say

when it will happen because it is the result of a lasting process that is already in progress.

The company valuation set of models using cash flow is not the saint grail of company

valuation but can help all investors in decision making, if used simultaneously with other

methods. Cash Flow and other advanced models can be applied on developing markets such as

the Croatian one, but further research has to be done.

References

1. Anthony, R., Reece, J.: Racunovodstvo, financijsko i upravljacko racunovodstvo, RRiF plus, Zagreb, 2004.

2. Copeland, T, et al.: Valuation Measuring and Managing the Value of Companies, McKinsey & Company,

Inc., New York, 2000.

3. Gulin, D., et al..: Racunovodstvo trgovackih drustava uz primjenu MSFI/MRS i poreznih propisa, Hrvatska

zajednica raunovoda i financijskih djelatnika, Zagreb, 2006. 4. Mills, C.C., Developing ratios for effective cash flow statement analysis, Journal of Accountancy, 11/91,

New York, 1991.

5. MRS 1, Medunarodni standardi financijskog izvjestavanja (MSFI) 2004.: ukljucujuci Medunarodne

racunovodstvene standarde (MRS), HZRIF, Zagreb, 2005.

6. MRS 7, Medunarodni standardi financijskog izvjestavanja (MSFI) 2004.: ukljucujuci Medunarodne

racunovodstvene standarde (MRS), HZRIF, Zagreb, 2005.

7. Mrsa, J.: Novine u standardiziranju financijskog izvjestavanja malih i srednje velikih poduzeca,

Racunovodstvo i Financije, Hrvatska zajednica racunovoda i financijskih djelatnika, 12/07, Zagreb, 2007.

8. Mrsa, J.: Biljeske uz financijske izvjestaje u malim i srednje velikom poduzecima, Racunovodstvo i

Financije, Hrvatska zajednica racunovoda i financijskih djelatnika, 12/07, Zagreb, 2007.

9. Mulford, C., Comiskey, E.: Creative Cash Flow Reporting, Uncovering Sustainable Financial Performance,

John Wiley & Sons, New Jersey, 2005.

10. Orsag, S.: Vrednovanje poduzeca, Infoinvest, Zagreb, 1997.

11. Zakon o racunovodstvu, NN 109/2007

12. www.Approach.pdf, pages.stern.nyu.edu/~adamodar/ (31.1.2008)

13. www.Fcfe.pdf,pages.stern.nyu.edu/~adamodar/New_Home_Page/valuation/val.htm#ch2 (27.1.2008)

14. www.Fcff.pdf,pages.stern.nyu.edu/~adamodar/New_Home_Page/valuation/val.htm#ch2 (27.1.2008)

15. www.businessweek.com/magazine/content/02_28/b3791114.htm

16. www.iasb.org/NR/rdonlyres/80B373BF-BB16-45AB-B3F7-8385CD4979EA/0/IAS1.pdf (26.1.2008.)

17. www.investopedia.com/articles/basics/05/062405.asp, (2.2.2008)

18. www.investopedia.com/university/dcf/, (27.1.2008)

19. www.investopedia.com/terms/f/freecashflow.asp (29.2.2008)

20. www.investopedia.com/terms/f/freecashflowfirm.asp, (29.1.2008)

21. www.investopedia.com/terms/freecashflowtoequity.asp, (29.1.2008)

22. www.winninginvesting.com/spot_red_flags_easier.htm (13.10.2009)

23. www.zse.hr/INA-R-A-Prospekt.pdf, (28.2.2008)

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