Debt-Adjusted Cash Flow (DACF): What it is, How it Works

What Is Debt-Adjusted Cash Flow (DACF)?

Debt-adjusted cash flow (DACF) is a financial metric that represents pre-tax operating cash flow (OCF) adjusted for financing expenses after taxes. It is most commonly used to analyze oil companies. Adjustments for exploration costs may also be included, as these vary from company to company depending on the accounting method used.

By adding the exploration costs, the effect of the different accounting methods is removed. DACF is useful because companies finance themselves differently, with some relying more on debt.

Understanding Debt-Adjusted Cash Flow (DACF)

Debt-adjusted cash flow (DACF) is often used in valuation because it adjusts for the effects of a company's capital structure. If a company uses a lot of debt, the commonly used Price/Cash Flow (P/CF) ratio may indicate the company is relatively cheaper than if its debt were taken into account.

P/CF is the ratio of the company's stock price to its cash flow. If a company employs debt, its cash flow may be boosted while its share price is unaffected, resulting in a lower P/CF ratio and making the company look relatively cheap.

The EV/DACF ratio removes this problem. EV, or enterprise value, reflects the amount of debt a company has, and DACF reflects the after-tax cost of that debt. The valuation ratio EV/EBITDA is used commonly to analyze companies in a variety of industries, including oil and gas. But in oil and gas, EV/DACF is also used as it adjusts for after-tax financing costs and exploration expenses, allowing for an apples-to-apples comparison.

Calculating DACF

Debt-adjusted cash flow is calculated as follows:

DACF = cash flow from operations + financing costs (after tax)

Enterprise Value/Debt-Adjusted Cash Flow

Analysts may look at debt-adjusted cash flow to help in fundamental analysis or generate valuation metrics for a company's shares. Enterprise Value to Debt-Adjusted Cash Flow (EV/DACF) is one such measure. Enterprise value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market capitalization.

EV includes in its calculation the market capitalization of a company but also short-term and long-term debt as well as any cash on the company's balance sheet. Enterprise value is a popular metric used to value a company for a potential takeover.

EV/DACF takes the enterprise value and divides it by the sum of cash flow from operating activities and all financial charges. The capital structures of various oil & gas firms can be dramatically different. Firms with higher levels of debt will show a better price-to-cash flow ratio, which is why some analysts prefer the EV/DACF multiple.

The EV/DACF multiple takes the enterprise value and divides it by the sum of cash flow from operating activities and all financial charges including interest expense, current income taxes, and preferred shares.