Equity cash flow represents funds a company receives from investors. While the most common form of equity financing is from common and preferred stock sales, companies can also receive direct investment from other companies and large private investors. Business owners and managers will measure the performance of this financing through a few common metrics. These metrics include return on equity, free cash flow to equity and the debt to equity ratio. Financial performance management is important because investors desire a return on their capital.
Return on equity is a basic financial performance metric that measures how well the company generates profits from equity cash flow. The basic formula is net income divided by total shareholder’s equity. Investors look at this metric to determine how well the company can take invested funds and generate more revenue through normal business operations. A negative return on equity means the company is losing money from invested capital, i.e. shareholders are losing a portion of their invested capital.
The free cash flow to equity formula measures the amount of money the organization makes from equity financing. This metric is often a better measurement of economic wealth, as it tracks the cash generated by the company. Free cash flow to equity is a bit more difficult to calculate. The formula is net income less net capital expenditures less change in working capital plus new debt less debt repayment. Investors like to see a positive equity cash flow, as it indicates the company has more cash to reinvest into the business or pay out in dividends. Dividends represent an immediate payback on capital from investors.
The final performance metric for measuring equity cash flow is the debt to equity ratio. This formula does not necessarily measure equity cash flow, but how the company uses external financing. Using too much debt financing indicates the company will have to pay out more money in interest to lenders, ultimately reducing the company equity cash flow. The formula for the debt to equity ratio is total liabilities divided by shareholder’s equity.
Cash flow is typically a more important financial measure, as net income — and earnings per share calculated from net income — are accounting figures. This means the figures are not necessarily a true indicator of economic wealth. When measuring investments, fundamental analysis techniques measure historical cash flow. This allows investors to look at the company behind the stock sold on open exchanges.
