Operating Cash Flow and interest expenses – (ThyssenKrupp vs. Kabel Deutschland, IFRS vs. US GAAP)
In my recent post to Kabel Deutschland, I made the following remark:
Interestingly, the “operating cashflow” does not include interest charges. In my opinion, interest charges are operating, as they have to be paid regularly and there is no discretion like dividends. So in my view Kabel Deutschland currently runs free cashflow negative and dividends are paid out from the increase in debt.
After some discussions, I was less sure about this myself so I thought it might be a good thing to look at this more closely.
Before jumping into “definitions” of how to calculate and report different cash flow definitions, one should take one step back and ask oneself:
What is “free Cash Flow” supposed to mean anyway ?
The current mantra for most “sophisticated” investors is that you should more or less forget earnings and concentrate on “free Cash flow” as this is the most important metric for determining the value of any (non financial) company.
“Free Cash Flow” in plain English should quantify the amount of money which is generated by a company over a certain period of time (usually 1 year) which can be used in a discretionary fashion to either grow the company, pay dividends, buy back shares etc.
In order to calculate this number, you normally start with operating cash flow, which in theory should contain all cashflows to operate the business on a going concern basis and then deduct cash out for normal Capex, i.e. investments required to ensure the “status quo” of the company.
Further one has to distinguish between two perspectives when deciding how to calculate Free Cash flow:
Free Cash flow to the firm vs. Free cashflow to equity
The single most difference between Firm/equity perspective is that in the “firm perspective” one assumes that the financing structure is discretionary. One wants to evaluate the whole value of the firm based on the firm wide discretionary cashflow.
However, with free cash flow to equity, I have to take the current financing structure as given and one has to calculate how much of discretionary cash flow is left for the shareholder. This of course implies, that interest charges are not discretionary for a shareholder but have to be subtracted from Free cash flow to equity.
This is especially important for highly leveraged companies where interest expenses can “eat away” a lot of discretionary cashflow.
So far so good, where is the problem ? The problem is that different companies report cashflow differently.
Let’s look at Thyssenkrupp for instance:
They start with Net income and adjust for depreciation etc. but not for interest expense. Interest expense ist therefore shown within Operating Cashflow (net finance expense was 168mn, maybe they didn’t bother with -1.3 bn operating cashflow.
Now let’s look at the 9M Kabel Deutschland Cashflow report:
We can see that other than Thyssen Krupp, Kabel Deutschland adds back interest expense to Operating CF.
Later on, we can see interest expense under Financing Cashflow:
Under US GAAP it is clear: Interest expense belongs to the Operating cashflow statement. Under IFRS however a company can can choose between Operating and Investing Cashflow (see here, 7.15)
So we can see, there is nothing explictly wrong with Kabel Deutschland from a reporting point of view, they just have chosen to report interest expenses under Financing cashflow.
There is an interesting paper to be found here which makes the following observations:
We find that firms with greater likelihood of financial distress and a greater probability of default make OCF-increasing classification choices. We further show that firms accessing equity markets more frequently and those with greater contracting concerns are also more likely to make OCF-increasing classification choices. Firms with negative OCF are less likely to make OCF-increasing classification choices.
So that is no surprise that a PE “boot strapped” company like Kabel wants to show higher OCF and FCF and opts for Financing Cashflow.
What to do & Summary?
In my opinion, you have to make sure first that you compare apples to apples if you look at two different companies and compare free cashflows. Make sure that you treat this consistently. I am not sure if all the US investors which hold the largest stakes in Kabel know about this small but important reporting difference.
Secondly, I personally think that interest expenses always should be deducted from Operating Expenses and therefore Free Cash Flow in any equity valuation exercise.
Imagine for instance a company which rents its building against a company which takes out a loan to buy the exact same building. In the first building, you would subtract the rent clearly from operating profit, so why would you not subtract the interest on the mortgage for the second company ?