Cash Flow Drivers
The components of a business evaluation model that drive a company’s cash flows
What are Cash Flow Drivers?
Cash flow drivers are the components of a business evaluation model that drive a company’s cash flows. The elements help financial analysts forecast a company’s future cash flow and build a predictive valuation of a company.
It is crucial to recognize and analyze all the relevant cash flow drivers for the business you evaluate. If certain drivers are omitted, it can lead to a skewed predictive model that will invariably lead to flawed decision-making by management.
Being able to put cash flow drivers into qualitative context and understanding comparative metrics towards its industry and peers can help you further determine the financial health and strength of the company you are modeling.
Below, we will briefly touch upon the cash flow drivers discussed in the Business Valuation course offered at CFI. Understanding what the drivers are and why they are relevant can help you in your career and financial modeling ability.
Summary
- Cash flow drivers are the components of a business evaluation model that drive a company’s cash flows.
- Being able to put cash flow drivers into qualitative context and understanding comparative metrics towards its industry and peers can help you further determine the financial health and strength of the company you are modeling.
- The cash flow drivers analyzed below are 1) Revenue, 2) Gross Margins, 3) EBIT(DA) Margins, 4) Working Capital, 4) Capital Expenditure, 6) Capital Structure.
Cash Flow Drivers: Which Are Important?
There are many different drivers of free cash flow. For our purposes, we will analyze the ones listed below:
- Revenues
- Gross Margins
- EBIT(DA) Margins
- Working Capital
- Capital Expenditures
- Capital Structure
Driver #1 – Revenues
A company’s revenues are the income it gains from selling its goods and services. Revenues can offer insight into how much a company is earning from the sale of its goods and services and how popular they really are in the marketplace and versus its competition.
Driver #2 – Gross Margins
Gross margins are a company’s net sales minus the costs of goods sold (COGS) divided by the total revenue. Gross margins help to determine how profitable an item or service actually is for a company.
Depending on the industry a company operates in, the margin can be found in different healthy ranges. For example, the apparel industry’s gross margins are much larger than in the gaming console manufacturing industry.
Driver #3 – EBIT(DA) Margins
The EBITDA margins of a company refer to its operating profitability. It is the profit before expenses like interest, taxes, depreciation, and amortizations are subtracted.
Driver #4 – Working Capital
Working capital helps to measure the liquidity of a company. It helps determine whether a company’s operating capital can cover its day-to-day operations and any unpredictable expenses that may arise.
Operating in uncertain markets makes working capital and access to it an important metric that can aid in determining a business valuation.
Driver #5 – Capital Expenditure
Capital expenditures are another critical cash flow driver. Understanding how much capital a company needs to maintain its assets is critical in determining a company’s long-term health.
Driver #6 – Capital Structure
Understanding how a company finances its capital asset expenditures is the last cash flow driver we will analyze. Does the company borrow money from the bank? Do they raise the capital through the issuance of bonds? Do they issue instruments like preferred shares? Or is it a combination of all the above?
Understanding all of the drivers above will help you develop a stronger interpretive lens when building your financial models and will allow you to describe both qualitatively and quantitatively their effects.
Additional Resources
CFI offers the Commercial Banking & Credit Analyst (CBCA)™ certification program for those looking to take their careers to the next level. To keep learning and advancing your career, the following resources will be helpful:
