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In corporate finance, Free Cash Flow (FCF) is cash flow available for distribution among all the securities holders after the company has made all the investments in fixed assets and working capital necessary to sustain ongoing operations. The securities holder includes equity holders, debt holders, preferred stock holders, convertible security holders, and so on. The value of a company’s operations is determined by the stream of cash flows that the operations will generate now and in the future. To be more specific, the value of operations depends on all the future expected free cash flows (FCF), defined as after-tax operating profit minus the amount of new investment in working capital and fixed assets necessary to sustain the business. Thus, the free cash flow represents the cash that is actually available for distribution to investors. Therefore, the way for managers to make their companies more valuable is to increase their free cash flow.
CALCULATION OF FREE CASH FLOW Free cash flow tracks the money. It's what you have left over at the end of the year, or quarter, after you pay all your bills and pay for any new capital expenditures. It is what you have left over to pay investors.
Element EBIT x (1-Tax) + Depreciation/Amortization - Changes in Working Capital - Capital expenditure = Free Cash Flow
Data Source Current Income Statement Current Income Statement Prior & Current Balance Sheets: Current Assets and Liability accounts Prior & Current Balance Sheets: Property, Plant and Equipment accounts
from Investment = Free Cash Flow Should a negative free cash flow be always considered bad? It depends. Therefore. which is the ratio of net operating profit after tax (NOPAT) to total operating capital. even if it causes negative cash flows. If the negative free cash flow is caused by the negative operating cash flow. rapidly growing firms do have negative free cash flows as they require external infusion of funds to support growth. Indeed. it is bad because it suggests that the firm is experiencing operating problems. 2 . On the other hand. there is nothing wrong with profitable growth. if negative free cash flow is caused by investments in fixed assets and working capital. One way to determine whether growth is profitable is by examining the return on invested capital (ROIC). If the ROIC exceeds the rate of return required by investors.Interest Exp)*(1-T) +Interest Exp+D&A-CAPEX-Net Change in WC Element Earnings Before Interest and Tax x (1-Tax) + Depreciation/Amortization . Data Source Current Income Statement Current Income Statement Prior & Current Balance Sheets: Current Assets and Liability accounts same as Statement of Cash Flows: section 1. from Operations Element Data Source Cash Flows from Operations Statement of Cash Flows: section 1.Capital Expenditure Statement of Cash Flows: section 2. it need not cause concern as long as these investments are expected to earn satisfactory returns. it means the firm is adding value.Changes in Working Capital = Cash Flows from Operations Therefore. from Operations .You can also calculate it by taking: (EBIT. then the negative free cash flow caused by high growth is nothing to worry about.
If free cash flow is declining over a number of time periods. Firms with declining free cash flow can expect a decline in earnings growth and worse. There is not a regulatory standard set for it so there are a couple of different ways it can be calculated. They may be reducing their costs. or may something. made. 3 . They may be efficiently managing their assets. that usually means that a growth in earnings is on the horizon for the firm. right.If you look at free cash flow across several years of firm data and it is growing. Keep in mind that free cash flow is not completely immune to accounting trickery. Items like accounts receivable and accounts payable can be manipulated regarding when payments are received. Firms with growing free cash flows are doing something. and recorded to make free cash flow look larger than it is. there may be dark clouds on the horizon for the company. They may be enjoying growth in revenue. They may be paying down their debt. They may have to take on increasing levels of debt and may experience declining liquidity.
2. including both shareholders and debt holders. such as paying too much to acquire some other company. pay off some of the debt. 3. and also sell some of its marketable securities. if managers fail to act in the best interest of shareholders. paying interest and dividends) and some are cash inflows (for example. For example. Any company does not have to use FCF to acquire operating assets. Repurchase stock from shareholders.THE USES OF FCF The free cash flow (FCF) is the amount of cash that is available for distribution to all the investors. In practice. issue new debt. a company might pay interest and dividends. but the net cash flow from these five is equal to FCF. Thus. there is evidence to suggest that some companies with high FCF tend to make unnecessary investments that don’t add value. Pay dividends to shareholders. since by definition FCF already takes into account the purchase of all operating assets needed to support growth. 4 . Buy marketable securities or other non operating assets after – tax interest expense. most companies combine these five uses in such a way that the next total is equal to FCF. issue debt and selling securities). 5. Some of these activities are cash outflows (for example. Unfortunately. that is. high FCF can lead to agency costs. keeping in mind that the net cost to the company is the Repay debt holders. There are five good uses of free cash flow: 1. Pay interest to debt holders. 4.
Let's take the treatment of capital expenditures to illustrate the difference between free cash flow and net income. One year. before depreciation. here is how net income and FCF compare: Year Net income 1 $1000 2 $ 750 3 $ 750 4 $ 750 5 $ 750 Total $4000 FCF $0 $1000 $1000 $1000 $1000 $4000 For free cash flow purposes. However. the amount paid on the truck is subtracted out as a capital expenditure in the first year. As its name implies. So. In the year of purchase. The truck will be depreciated over 4 years at $250 per year. and assuming everything else came to zero. net income would be only $750. FCF is $1000. free cash flow is calculated on a purely cash basis whereas net income is calculated on an accrual basis in accordance with generally accepted accounting principles (GAAP). would be $1000 because depreciation is added back in. Cash from operations. the company buys a truck for $1000 to help in deliveries. FCF for that year would be $1000 cash from operations (in this case. So for those 4 years. Capital expenditures would be zero. For the 5 years of this example. though. for the next four years. Suppose a company has $1000 of net income every single year.FREE CASH FLOW VS. NET INCOME Free cash flow is used by some instead of (or in conjunction with) net income as a measure of a company's profitability. the cost of the truck is depreciated over its useful life 5 . equal to net income) minus $1000 capital expenditure (the truck) equal $0.
for net income purposes. MORE WAYS TO CALCULATE Free cash flow to the firm (FCFF) This measures how much cash is available for all claim holders in the firm (debt holders and share holders) after all taxes and needs for reinvestment have been met. In other words.CapEx + Depreciation . free cash flow and net income should roughly equal each other. FCFE = Net income .tax rate) . Negative FCFF means that the firm will have to raise more cash. this pretends that there is no interest expense or tax benefit from that interest expense. Positive FCFF means that there is cash to either service debt (through interest payments or principal repayments) and / or service the equity holders (through dividends or share repurchases).Debt repaid + Debt issued 6 . Free cash flow to equity (FCFE) This measures how much cash is available to equity holders (shareholders) after tax needs. debt needs.Change in NCWC . either through issuing more debt or selling more equity. over the long run. and growth needs have been met.Change in non-cash working capital This starts with operating profit and then subtracts tax so that it does not include the tax benefit from paying interest. As you can see.CapEx + Depreciation . FCFF = EBIT (1 . but over the short term there will be timing differences.
so this calculation includes that. Another argument in favor is that it's possible to have positive net income but negative free cash flow. However. free cash flow can also be manipulated by delaying items such as capital expenditures. 7 . Without free cash flow (or financing). They can be used in conjunction with each other to identify problem areas. When negative. a company can't pay its bills and is in danger of bankruptcy. it implies that the firm must issue new equity to raise cash. When positive. free cash flow and net income do not have to be an either/or proposition. ARGUMENTS FOR AND AGAINST Proponents of free cash flow argue that free cash flow is harder to manipulate than net income since it isn't subject to accounting shenanigans. it shows what can be paid out to equity holders (as a dividend or repurchased stock) without doing any damaging the firm's operations or growth opportunities. By analyzing the differences between the two. free cash flow can often jump around from year to year. Of course.Debt is a source of cash for equity holders. Since capital expenditures are frequently lumpy. investors can gain useful insights. An argument in favor of net income is that it's smoother than free cash flow.
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