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 entites
1
.
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
322 Tomislav Jeletic
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.
Cash Flow and Company Valuation Analysis... 323
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;
324 Tomislav Jeletic
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
Cash Flow and Company Valuation Analysis... 325
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:

326 Tomislav Jeletic
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
Cash Flow and Company Valuation Analysis... 327
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;
328 Tomislav Jeletic
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. GAAP
2
. The process is shown in
the Figure below (Figure 1
3
).


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
=
Cash Flow and Company Valuation Analysis... 329
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 expenses
4
. 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 Demodarna
5
.
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.
follows
6
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 kunas
7
).

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.
330 Tomislav Jeletic
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
r
VALUE
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.
Cash Flow and Company Valuation Analysis... 331
The companny value is calculated as follows
8
:

) (
1
n
g WACC
FCFF
Value

= (2)
Where:
FCFF
1
the expected FCFF for the next year
WACC waged avarage capital cost
g
n
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 follows
9
:
) 1 ( Re Tc Rd
V
D
V
E
WACC + = (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 formula
10
:

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).
10
See: Fcff.pdf, pages.stern.nyu.edu/~adamodar/New_Home_Page/valuation/val.htm#ch2, (27.1.2008); Mulford,
Comiskey (1997: 360).

332 Tomislav Jeletic
n
g r
FCFE
P

=
1
0
(4)
Where:
P
o
present value of the company
FCFE
1
expected Free Cash Flow for Equity in the next year
r company's equity cost
g
n
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 company
11
.
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).
Cash Flow and Company Valuation Analysis... 333
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 2012
12

(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.

334 Tomislav Jeletic
789 . 94
045 , 0 0759 , 0
2.929
) (
1
=

=
n
g WACC
FCFF
Value (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 g
n
is equal to the data used in
(5).
006 . 72
045 , 0 0759 , 0
225 . 2
1
0
=

=
n
g r
FCFE
P (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 :

Cash Flow and Company Valuation Analysis... 335
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
=
Cash flow from operations
Avarage of liabilities and capital

Return on capital
=
Cash flow from operations
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 employees
13
. 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).
336 Tomislav Jeletic
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 Bank
14
, 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.
Cash Flow and Company Valuation Analysis... 337
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.
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Financije, Hrvatska zajednica racunovoda i financijskih djelatnika, 12/07, Zagreb, 2007.
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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
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18. www.investopedia.com/university/dcf/, (27.1.2008)
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20. www.investopedia.com/terms/f/freecashflowfirm.asp, (29.1.2008)
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23. www.zse.hr/INA-R-A-Prospekt.pdf, (28.2.2008)
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