This article explains discretionary cash flow in simple words.
Discover its uses and importance, and even calculation.
Let’s navigate money matters together.
What is discretionary cash flow
Discretionary cash flow is the remaining amount of money left over after funding all projects and paying expenses.
Using this, you can determine the actual value of a company, which helps when selling it. A higher DCF means a higher price compared to other organisations in the same field.
It also aids in the acquisition of other companies. Calculating DCF shows how much we will earn by acquiring a specific company.
In other words, the amount of money a buyer can earn from the business is described as DCF.
It is essential to check how effectively funds are distributed across the project. Its management team’s responsibility is to allocating funds to run a project that yields a good return on investment.
How to calculate discretionary cash flow
Calculating discretionary cash flow is simple and requires just formula. Let’s go through the step by step.
Step 1: Take pre-tax earnings from the income statement.
Step 2: Add all non-operating expenses and subtract non-operating income.
Step 3: Add non-recurring expenses and deduct non-recurring income.
Step 4: Then add depreciation and amortization costs.
Step 5: Add all interest costs and subtract interest income (if available).
Step 6: Finally, add the business owner’s compensation.
There is an additional step. If a company has more than one owner, exclude one, and the other one will be considered an employee, categorising their compensation as expenses.
After following all the steps, you will arrive at the value of DCF.
Buyers and sellers’ discretionary earnings
Discretionary cash flow is used to determine the value of a company. When an owner wants to sell their company, they calculate DCF, which is called the seller’s discretionary earnings.
On the other side, the buyer also calculates DCF to know the actual price of the company. Using this, the buyer can determine if they will gain a return on investment or not. This is what is called the buyer’s discretionary cash flow.
Both buyer and seller calculating value are not necessarily the same. Some items are common, while others are not. For example, non-operating expenses and income might be the same for both, but non-recurring expenses and income could differ.
Wages are different for both, the seller may have a loan on assets, whereas the new owner might have enough money to pay the loan.
DCF is not only used for buyers and sellers. It also holds other importance. Let’s explore its uses.
Use and importance of DCF
Here, I mentioned some other uses of DCF to highlight its importance.
Investment: Using discretionary cash flow as a parameter, investors can determine how profitable a company is. If DCF grows over time, it means the company is heading in a positive direction and is good to invest in.
However, a decline in DCF over time indicates negative cash flow, suggesting poor performance of the company . Note that it is possible for organisations to invest more money in assets and capital expenditures to boost future growth.
Company Expenses: In most cases, larger companies use their DCF to provide bonuses to employees, buy back stocks, pay off debts, and distribute dividends to investors.
Allocating the leftover money to these activities helps the company in various ways, such as attracting more investors and clearing loan debts as soon as possible.
Funding other investments: You can use a portion of your DCF to fund other projects that will yield a good return on investment in the future.
Some entrepreneurs follow this rule. As a small businessman or employee, you can also implement this method to become financially strong. You just need to set aside a small portion of your salary earned from your job.
Improve Lifestyle: While not directly related to your business or financial perspective, you can use discretionary income to fund your lifestyle.
You can achieve your dream by covering all expenses through DCF. Here, we can make our lives better using DCF, and it is essential to have a good life.
Remember, paying yourself one dollar is less invest in your business growth. So, balancing life and business is important.
Conclusion
Here was all the information about discretionary cash flow.
Now, calculate your favourite company’s DCF and write down the value in the comment section.
Also, you can increase your financial knowledge by reading my other blog posts. So, check those out!