What is a Free Cash Flow (FCF)?

Meaning of FCF Explained in Detail

It is a measurement of a company’s financial performance and health. The more FCF a company has, the better it is. It is an economic term that truly determines what is available to distribute among the company’s security holders. So, FCF can be a tremendously useful measure for understanding the true profitability of any business. It is harder to manipulate, and it can tell a much better story of a company than more commonly used metrics like profit after taxProfit After TaxProfit 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 a portion of cash that remains in the hands of a company after paying all its capital expendituresIts Capital ExpendituresCapex 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 PayablesAccounts 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. Therefore, FCF is calculated from the cash flow statement of the companyCash Flow Statement Of The CompanyA Statement of Cash Flow is an accounting document that tracks the incoming and outgoing cash and cash equivalents from a business.read more. A business that generates a significant amount of cash after an assured interval is considered the best business than other similar businesses. Since you have to pay all your routine bills like salary, rent, and office expenses in cash, you cannot bear it from your net income. Thus, its business’s ability to generate some money matters to stakeholders, especially those who are warier about the liquidity of the company Liquidity Of The Company Liquidity is the ease of converting assets or securities into cash.read morethan its profitability like business suppliers. Therefore a company with sound working capital managementSound Working Capital ManagementWorking 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 liquid signals, and FCF is on top.

Hence, in corporate finance, most projects are selected based on their timing of cash inflows and outflows rather than their net income. Because the income statement includes all cash and non-cash expenditures like depreciation and amortization, these non-cash expendituresNon-cash ExpendituresNon-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 money for that particular period.

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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 total of net income and non-cash expenses like depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year. read more and amortizationAmortizationAmortization 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. 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

The non-cash expenses include depreciation and amortization. Here, in the income statement, we have only depreciation figures provided. Therefore, 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

Changes in working capital = -75.

It 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 expenditureCalculate Capital ExpenditureCapital Expenditure is the total amount that a Company spends to buy & upgrade its fixed assets like PP&E (Property, Plant, Equipment), technology, & vehicles etc. You can calculate it by adding the net change in PP&E value over a given period to the depreciation expense for the same year. read more –

Gross PPE Approach –

Capital Expenditure = Change in Gross property plant and equipmentProperty Plant And EquipmentProperty 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

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 = 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 will be: –

= $168 + $150 – $75 – $300 

= -$57.

Types of Free Cash Flow (FCF)

There are two types: FCFF and FCFE.

#1 – Free Cash Flow to the Firm (FCFF)

FCFF means the ability of the business to generate cash, netting all its capital expenditures. One can calculate the FCFF by using cash flow from operations or by using the company’s net income. The formulas to calculate Free Cash Flow to the Firm (FCFF): –

To learn more about FCFF, you may look at this detailed article FCFFFCFFFCFF (Free cash flow to firm), or unleveled cash flow, is the cash remaining after depreciation, taxes, and other investment costs are paid from the revenue. It represents the amount of cash flow available to all the funding holders – debt holders, stockholders, preferred stockholders or bondholders.read more

#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 company’s equity shareholders 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 EquityFCFE (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 its expansion only if it comprises adequate FCF. So, it is often desirable for businesses to hold more FCF to boost the company’s growth. However, the reverse of that is not always necessarily true. A company with a low FCF might have made considerable investments in its current capital expenditures, which will benefit the company to growth in the long run. Investors like to invest in several small businesses with steady and predictable growth in their free cash flows. Their probabilities of making a return on their investments will increase with the development of the companies.

The analysts are more concerned about cash inflows generated by the Company’s operating activitiesOperating ActivitiesOperating 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 as it purely predicts its actual performance. Operating cash flowOperating Cash FlowCash 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 company’s core business. It 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 in one period sooner or later.

Conclusion and Use in Valuation

FCF can provide a useful Discounted Cash Flow Discounted Cash Flow Discounted cash flow analysis is a method of analyzing the present value of a company, investment, or cash flow by adjusting future cash flows to the time value of money. This analysis assesses the present fair value of assets, projects, or companies by taking into account many factors such as inflation, risk, and cost of capital, as well as analyzing the company’s future performance.read more 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 mature businesses. Like price-to-earnings ratiosPrice-to-earnings RatiosThe 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 help value a business. To calculate a price-to-free-cash-flow ratio, you can divide the share price by the free cash flow per share or the market cap of a companyMarket Cap Of A CompanyMarket capitalization is the market value of a company’s outstanding shares. It is computed as the product of the total number of outstanding shares and the price of each share.read more divided by its total free cash flow.

The Free Cash Flow YieldCash Flow YieldThe free cash flow yield is a financial ratio that compares the free cash flow per share to the market price per share to determine how much cash flow the company has in the event of liquidation or other obligations. read more is an overall return evaluation ratio of a stock, determining the FCF per share a company is expected to earn against its market price per share. The ratio is calculated by dividing the FCF per share by the share price. Generally, the higher the ratio, the better it is. And many people prefer free cash flow yield as a valuation metric over earnings yieldEarnings YieldEarnings Yield informs the investor about how much he will earn for each dollar invested in the company and is calculated by dividing earnings per share by the stock price per share. This ratio helps an investor in comparing two or more companies or between investing in stocks versus investing in risk-free securities.read more.

Ultimately, FCF is just another metric. It does not 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 is a guide to Free Cash Flow and its meaning. We discuss FCF in valuation, practical examples, the use of FCF in valuation, and its types. You may also learn more about valuations from the following articles: –

  • Operating Cash Flow FormulaCash Flow vs. Free Cash FlowAlibaba FCF Valuation ModelEnterprise Value (EV) Meaning