Explanation of common financial terms that confuse investors

I will be covering most common asked questions. Feel free to ask if I missed any and I will continue to add o the list.

What is non-cash item?
Any item that doesn't impact cash flow. For example depreciation is a non-cash item or the interest expense of zero coupon bond.

What is capital expense?
Any expense that is needed for company to continue growing is called capital expenditure. This may include setting up new plants, R&D, acquitions or anything you can think of company is investing money that is for growth and not for operational purpose is categorized as capex.

What is Free cash flow ?
Any cash flow left after taking away any reinvestment needs is called free cash flow. Remember this cash flow is before any interest expense. So lets take example of Wipro.

Source http://in.reuters.com/money/quotes/incomeStatement?symbol=WIPR.BO

For year ending Mar-09

Operating income=45196
But remeber operating expense includes interest expense of 2400.
So add this back to operating income resulting in
EBIT (earnings before interest and tax)=45196+2400=47596

Now lets calculate the tax rate for wipro in this year.
Provision for taxes=6460
Net Income Before taxes=45196
Tax rate=6460/45196=14.29%

EBIT=47596
taxes(@14.29%)=6803
EBI=47596-6803=40792

Now We will add any non cash items in EBI. The major item is depreciation.
Depreciation=497

How much was wipro's capital expenditure.
Lets look into its cash flow statement for Mar-09
http://in.reuters.com/money/quotes/incomeStatement?stmtType=CAS&perType=ANN&symbol=WIPR.BO

Look under cash from investing activities. There is a capex of 16746.
Well i don't know what other investing is but lets take for argument sake just the capex.
Although there are several other items that company expense like R&D etc which one needs to account for capex.

So what we have is:
EBI=40792
+Dep=497
-Capex=16746

This equals Free cash flow=40792+497-16746=24543

This is the cash flow available to the firm(available to debt holders and equity holders).

We also call it cash flow available at the firm level


What is Enterprise Value

I am sure you can find the formula for EV from google to be

EV= marketcap+Net debt-minority interest

What does it actually mean ?

It represents the present value of all  future free cash flows. (see above what is free cash flow)

Also, you can say it is the value of the company attributed to its operational activities. So does that mean there is value coming from non-operational activities. Yes, some of them are :

1. cash
2. minority interest in other companies

Wipro for example has cash of Rs.41 billion as of June-09, so computing the total company value(available to debt and equity holders) will be sum of enterprise value and Rs.41 billion. If it holds any minority interest in other companies we will also add that at the market value to the above number.

This is how we compute the total firm/company value and you must have seen it may be greater than the enterprise value depending on other non-operational value items like cash or minority interest.

So how do we deduce equity value from above.

We know the total firm value= EV+cash+minority interest
Also we know firm is composed of Debt holders and equity holders so
We can say firm value=debt value+equity value

Lets assume that book value is same as market value for debt. We can read off balance sheet the existing debt. For wipro in this example, looking at interim balance sheet for June-09, we see
Short-term-debt=9433
Total long term debt=47986
So total debt=9433+47986=57419 or 57 billion

So for wipro:
debt value+equity value=EV+cash+minority interest

Lets assume wipro has no minority interest and from DCF model EV comes out to be 835billion

Therefore equity value(or market cap)=EV+cash-debt value= 835+41-57=819billion

You may be wondering how did I get the exact same market cap, actually I cheated to derive EV from today'smarket cap. But thats not the point .

Hope now you understand what are the different value components of firm and what is enterprise value.