What is a Free Cash Flow (FCF)?
Free cash flow (FCF) is the cash flow to the firm or equity after all the debt and other obligations are paid off. It is a measure of how much cash a company generates after accounting for the required working capital and capital expenditures (CAPEX) of the company.
Meaning of FCF Explained in Detail
It is a measurement of a company’s financial performance and health. The more FCF a company have, the better it is. It is a financial term that truly determines what is exactly available to distribute among the security holders of the company. So, FCF can be a tremendously useful measure for understanding the true profitability of any business. It’s harder to manipulate, and it can tell a much better story of a company than more commonly used metrics like Profit After Tax.
FCF is nothing but a portion of cash remains in the hands of a company after paying all its capital expenditures like purchasing new machinery, equipment, land & building, etc. and satisfying all its working capital needs like accounts payables. FCF is calculated from the Cash Flow Statement of the company. A business that generates a significant amount of cash after an assured interval is considered to be the best business than other similar businesses, as you have to pay all your routine bills like salary, rent, office expenses in cash only, and you can’t bear it from your Net Income. Thus, its business’s ability to generate cash that really matters to stakeholders, especially those who are more wary about the liquidity of the company than its profitability like suppliers of the business. A company with sound working capital management provides strong and sustainable liquidly signals, and FCF is on top of that.
Hence, in Corporate Finance, most of the projects are selected on the basis of their timing of cash inflows and outflows rather than its Net Income. Because the income statement includes all cash as well as non-cash expenditures like depreciation & amortization, however, these non-cash expenditures are not the actual outflow of cash for that particular period.
Free cash Flow Formula
Below is the simple Free Cash Flow Formula
Free Cash Flow Calculation
Calculate FCF for the year of 2008
Step 1 – Cash Flow From Operations
Cash Flow from Operations is the sum total of Net Income and non-cash expenses like Depreciation and Amortization. In addition, we add the changes in working capital. Please note this change in the working capital could be positive or negative.
Therefore, cash flow from Operations = Net Income + Non Cash Expenses +(-) Changes in working capital.
Step 2 – Find the Non Cash Expense
Noncash expense includes depreciation and amortization. Here in the income statement, we have only depreciation figures provided. We will assume that amortization is zero.
Step 3 – Calculate Changes in working capital
We see from above, changes in working capital = Accounts receivables (2007) – Accounts receivables (2008) + Inventory (2007) – Inventory (2008) + Accounts Payable (2008) – Accounts Payable (2007)
changes in working capital = 45 – 90 + 90 – 120 + 60 – 60 = -75
This means that there has been a cash outflow of -$75 due to changes in working capital.
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Step 4 – Find out the Capital Expenditure
Since we are not provided with the cash flow statement, we will use the balance sheet and the income statement to derive these figures. There are two ways to calculate capital expenditure –
Gross PPE Approach –
Capital Expenditure = change in Gross Property Plant and Equipment (Gross PPE) = Gross PPE (2009) – Gross PPE (2007) = $1200 – $900 = $300
Please note that this is a cash outflow of – $300
Net PPE Approach
Capex = change in Net PPE + Depreciation & Amortization = Net PPE 2008 – Net PPE 2007 + Depreciation and Amortization =
(1200-570) – (900-420) + $150 = 630 – 480 + 150 = $300
Please note that this is a cash outflow of – $300
Step 5 – Combine all the above components in FCF Formula
We can combine the individual elements to find a long FCF Formula and calculate Free Cash Flow.
The FCF Formula is equal to
Net Income + Depreciation and Amortization +(-) Accounts receivables (2007) – Accounts receivables (2008) + Inventory (2007) – Inventory (2008) + Accounts Payable (2008) – Accounts Payable (2007) – (Net PPE 2008 – Net PPE 2007 + Depreciation and Amortization)
So FCF calculation = $168 + $150 – $75 – $300 = -$57
Types of Free Cash Flow (FCF)
There are basically two types – one is FCFF, and another is FCFE.
#1 – Free Cash Flow to the Firm (FCFF)
FCFF simply means the ability of the business to generate cash netting of all its capital expenditures. One can calculate the FCFF by using Cash Flow from Operations or by using Net Income of the company. The formulas to calculate Free Cash Flow to the Firm (FCFF) is;
To learn more about FCFF, you may look at this detailed article FCFF
#2 – FCFE
FCFE is a cash flow available for equity shareholders of the company. The amount shows how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks after all expenses, reinvestments, and debt repayments are taken care of. The FCFE is also called the levered free cash flow. The formula to calculate Free Cash Flow to Equity is:
To learn more about Free Cash Flow to Equity, you may look at this detailed article Free Cash flow to Equity
Importance of Free Cash Flow
A company can expand, develop new products, pay dividends, reduce its debts or seek any possible business opportunities for the time being necessary for the expansion of the company, only if it comprises adequate FCF. So, it is often desirable for businesses to hold more FCF to boost the growth of the company. However, the reverse of that is not always necessarily true, a company with low FCF might have made huge investments in its current capital expenditures, and that will benefit the company to grow in the long run. Investors like to invest in a number of small businesses that are having steady and predictable growth in its Free Cash Flows so that their probabilities of making a return on their investments will increase with the growth of the companies.
The analysts are more concern about cash inflows generated by the operating activities of the company, as it purely predicts the actual performance of the company. Operating Cash Flow only includes cash generated by the core business of the company and ignores the influence of abnormal gains or losses/expenditures like liquidating the undertaking of the company or lagging suppliers’ payment and many other strategies of similar nature to record cash flow one period sooner or later.
Conclusion and Use in Valuation
FCF can provide a useful Discounted Cash Flow Analysis technique that can derive the value of a free cash flow firm or the value of the firm’s common equity. Many people use FCF as a substitution for earnings when valuing businesses that are mature in nature. Like price-to-earnings ratios, price-to-free-cash-flow ratios can be useful in valuing a business. To calculate a price-to-free-cash-flow ratio, you can simply divide the price of a share by the free-cash-flow per share or the market cap of a company divided by its total free cash flow.
The Free Cash Flow Yield is an overall return evaluation ratio of a stock, which determines the FCF per share a company is expected to earn against its market price per share. The ratio is calculated by taking the FCF per share divided by the Share Price. Generally, the higher the ratio, the better it is. And many people prefer to Free Cash Flow yield as a valuation metric over earnings yield.
Ultimately, FCF is just another metric, and it doesn’t tell you everything, nor will it be used for every kind of company. But observing that there is a very big difference between income and FCF will almost certainly make you a better investor.
Free Cash Flow (FCF) Video
This article has been a guide to Free Cash Flow. Here we discuss what is FCF, FCF Formula, calculations along with practical examples. We also look at types of free cash flow (FCFF and FCFE) along with its importance in valuations. You may also learn more about valuations from the following articles –