Free Cash Flow (FCF) is the amount of money that a corporation generates after deducting cash outflows for operating expenses and capital asset maintenance. Depending on the audience and the data provided, there are different approaches to calculating FCF.
Meaning of Free Cash Flow
FCF is referred to as a company’s cash flow or equity after the payment of all debt and associated financial obligations. It acts as a measure of how much cash a business generates or has left over after taking into account the amount of necessary working capital and capital expenditure. It indicates a company’s ability to pay off debt, distribute dividends, repurchase stock, and promote economic expansion—all significant tasks from the viewpoint of an investor. FCF is significant to investors and business analysts because it illustrates the amount of available cash a company has. Without FCF, it can become tough for a company to carry out activities that can help business development, make acquisitions or reduce debt. FCF allows a company to pursue opportunities that enhance shareholder value.
Types of Free Cash Flow
Free Cash Flow to the Firm (FCFF)
FCFF refers to a company’s ability to make cash after deducting all of its capital expenditures. If the FCFF value is positive, the company has cash available after expenses. The FCFF can be calculated using the cash flow from operations. Alternatively, one might calculate the same using a company’s net income. The formula to calculate FCFF is
FCFF = Cash Flow from Operating Activity(CFO) – Capital Expenditures(CAPEX)
Free Cash Flow to Equity (FCFE)
FCFE is a cash flow that is available for the company’s equity investors. The figure depicts the amount of cash available for distribution to the company’s equity owners as dividends or stock buybacks after the payment of all costs, reinvestments, and debt. Analysts frequently use the FCFE metric to estimate a company’s value. Leverage free cash flow is another name for the FCFE. To determine free cash flow to equity, one can use the following formula:
FCFE = FCFF + Net Borrowing – Interest Amount*(1-tax)
How to Calculate Free Cash Flow?
There are three alternative ways to calculate free cash flow. Even after using different data, the result should be the same irrespective of the method. The three methods used are operating cash flow, sales revenue, and net operating profits.
Using Operating Cash Flow
The most common method is to utilise operational cash flow to determine FCF since it is the simplest and uses two figures that can be easily located in financial statements: operational cash flow and capital expenditure.
Free Cash Flow = Operating Cash Flow − Capital Expenditures
Using Sales Revenue
The focus of using sales revenue is on the revenue that a firm makes through its operations, after deducting the costs involved in producing that income. Therefore, this method uses the income statement and balance sheet as its information source.
Free Cash Flow = Sales Revenue − (Operating Costs + Taxes) − Required Investments in Operating Capital
Using Net Operating Profits
Using net operating profits to calculate FCF is similar to using sales revenue to calculate the same though this method utilises operating income. The amount of profit made from ongoing operations is operating income. Administrative, selling or general expenses are examples of naturally recurring costs incurred to operate a company.
FCF = Operating Profit After Taxes − Investment in Operating Capital
Example of Calculation of FCF
Company A’s income statement for a financial year indicates:
|Cash Flow from Operating Activities||₹50,67,000|
|Expenditure on Machinery||₹15,56,700|
|Expenditure on Furniture||₹20,22,200|
|Capital Expenditure||₹15,56,700 + ₹20,22,200 = ₹35,78,900|
Therefore, Free Cash Flow = ₹50,67,000 – ₹35,78,900 = ₹14,88,100
Company A has a significant amount of free cash flow which it may utilise to reduce debt, pay dividends and grow operations.
Advantages of FCF
- Boost Company’s Growth: Only when a company has sufficient FCF can it flourish, create new goods, pay dividends, pay off debt, or look for any potential business prospects. So, to promote corporate growth, it is frequently beneficial for companies to hold greater FCF.
- Estimate Company’s Performance: This metric helps analysts and investors to identify businesses that exhibit growth. They can use it to assess whether a company is paying dividends or not. It helps determine whether or not the dividend the company pays differs from its actual ability to pay. It also helps in coordinating available cash with business profitability.
- Aid in Decision Making: Individuals who want to join a partnership business model frequently search for a business that can generate steady profits. Before making a choice, they consider a company’s FCF and determine the feasibility of its operations to gauge the same. A business with strong free cash flow is favoured above others.
Disadvantages of FCF
- Calculation for lengthy durations: Capital expenditure fluctuates between industries and between financial years. The FCF of a company must therefore be measured over a long period against the background of the industry.
- Problem with High FCF: It may also be a sign that the business is not making significant investments in its endeavour.
- Problem with Low FCF: It is not always indicative of a company’s poor financial health. It may also represent growth and expansion. Therefore, it can be said that it is a crucial financial indicator of the efficiency and profitability of a company. However, to obtain a more precise picture of a company’s financial health, business owners, investors and analysts must also employ other financial measurements.
Frequently Asked Questions
Free cash flow is a measure of how much money a company has available to invest or give to shareholders and debtors without affecting operating cash flow. Poor cash flow does not always indicate that a company is not financially stable. It could just be investing in future growth.
A sustainable free cash flow margin of above 10% is typically regarded as a good free cash flow. A dividend is a financial reward made to stockholders. Therefore, if a corporation can pay its dividend out of free cash flow, it may be safer and more sustainable.
While free cash flow is used to determine the present value of the firm, cash flow determines the net cash inflow of the operating, investing, and financing operations of the business. Cash flow has a much broader range while free cash flow has a limited range. An income statement is required for the preparation of both cash flow and free cash flow.
The free cash flow is utilised in mainly five ways which include paying dividends, repurchasing shares, paying down debt, reinvesting in the company and making acquisitions like acquiring other companies.