Free Cash Flow (FCF)

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 TaxProfit After Tax Profit After Tax is the revenue left after deducting the business expenses and tax liabilities. This profit is reflected in the Profit & Loss statement of the business.read more.

FCF is nothing but a portion of cash remains in the hands of a company after paying all its capital expendituresIts Capital Expenditures Capex or Capital Expenditure is the expense of the company's total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more like purchasing new machinery, equipment, land & building, etc. and satisfying all its working capital needs like accounts payablesAccounts Payables Accounts payable is the amount due by a business to its suppliers or vendors for the purchase of products or services. It is categorized as current liabilities on the balance sheet and must be satisfied within an accounting period.read more. FCF is calculated from the Cash Flow Statement of the companyCash Flow Statement Of The Company Statement of Cash flow is a statement in financial accounting which reports the details about the cash generated and the cash outflow of the company during a particular accounting period under consideration from the different activities i.e., operating activities, investing activities and financing activities.read more. 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 Liquidity Of The Company Liquidity shows the ease of converting the assets or the securities of the company into the cash. Liquidity is the ability of the firm to pay off the current liabilities with the current assets it possesses.read morethan its profitability like suppliers of the business. A company with sound working capital managementSound Working Capital Management Working Capital Management refers to the management of the capital that the company requires for financing its daily business operations. It is important for the company in order to maximize its operational efficiency, manage its short term liabilities and assets properly, avoiding the underutilization of the resources and avoiding the overtrading, etc.read more 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 expendituresNon-cash Expenditures Non-cash expenses are those expenses recorded in the firm's income statement for the period under consideration; such costs are not paid or dealt with in cash by the firm. It involves expenses such as depreciation.read more are not the actual outflow of cash for that particular period.

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For eg:
Source: Free Cash Flow (FCF) (wallstreetmojo.com)

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 AmortizationAmortization Amortization of Intangible Assets refers to the method by which the cost of the company's various intangible assets (such as trademarks, goodwill, and patents) is expensed over a specific time period. This time frame is typically the expected life of the asset.read more. 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.

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 EquipmentProperty Plant And Equipment Property plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. read more (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 EquityFree Cash Flow To Equity FCFE (Free Cash Flow to Equity) determines the remaining cash with the company's investors or equity shareholders after extending funds for debt repayment, interest payment and reinvestment. It is an indicator of the company's equity capital managementread more

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 activitiesOperating Activities Operating activities generate the majority of the company's cash flows since they are directly linked to the company's core business activities such as sales, distribution, and production.read more of the company, as it purely predicts the actual performance of the company. Operating Cash FlowOperating Cash Flow Cash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more 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 ratiosPrice-to-earnings Ratios The price to earnings (PE) ratio measures the relative value of the corporate stocks, i.e., whether it is undervalued or overvalued. It is calculated as the proportion of the current price per share to the earnings per share. read more, 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.

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