What Is Free Cash Flow: Its Importance, Formula And How To Calculate It
Free cash flow (FCF) refers to the cash left within a company after it pays for its operational activities and capital expenditure. This strongly indicates a company’s growth and future prospects since FCF is needed to support business operations.
How to Calculate Free Cash Flow?
You need to assess a firm’s cash flow statement to start with free cash flow calculation. That said, FCF helps determine a company’s profitability, as it excludes non-cash expenses in the income statement.
It also includes working capital change and expenses for equipment. The calculation of free cash flow can be done by using this FCF formula:
FCF = Operating cash – Capital expenditure
If a company decides not to disclose the operating cash or capital expenditure, there are alternative methods to calculate the FCF, specifically:
- FCF = Sales revenue – Investments for operating capital
- FCF = Operating profit including taxes – operating capital investment
Why is Calculation of Free Cash Flow Important?
The free cash flow model is crucial because it indicates a company’s financial standing and its capacity to invest in new business ventures. The amount of cash flow that might be available for distribution to investors in the form of dividends can also be estimated by assessing the free cash flow statement.
That said, there are various instances when a business can declare a positive free cash flow. Some of them are:
- Selling major corporate assets
- Delaying capital expenditures
- Minimising market expenditures
- Delaying accounts payable payment
- Foregoing a dividend, and more
Please note that FCF is prone to short-term viability. Thus, many investors tend to look at a company’s net income. However, when examined in the long term, free cash flow can provide a better outlook on a firm’s operational results.
Benefits of Calculating Free Cash Flow
The advantages of calculating the free cash flow of an organisation are:
- Helps determine whether a company pays dividends
- Enables to determine if the dividend a company pays differs from its actual payment capacity
- Helps to range a company’s cash with its profitability
- Helps determine a company’s repayment capacity
- Assist creditors in deciding if they should sanction a loan to a company or not
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Limitations of Free Cash Flow?
Besides the various advantages mentioned above, there are also a few disadvantages of calculating the FCF of an organisation.
- Capital expenditure changes from year to year and also varies across different industries. Thus, you will have to calculate the firm’s FCF for the long term against the backdrop of the industry to get an accurate assessment.
- A very significant free cash flow might indicate that a firm does not invest enough toward its business activities.
- A low FCF does not necessarily signify poor financials. It might mean that a company spends heavily on expansion and growth.
How does Growth Impact Free Cash Flow?
An organisation’s growth might also impact its free cash flow. If a business is expanding quickly, it must be investing a lot in inventory and accounts receivable. This will increase its working capital investment and reduce the amount of free cash flow.
In contrast, when a business shrinks, it converts some amount of working capital to cash as it pays off receivables and liquidates inventory. This results in an increased amount of cash flow.
Impact of Repatriation on Free Cash Flow
Businesses have the ability to repatriate cash from foreign subsidiaries or sister companies. These can be dividends paid by a foreign subsidiary to the parent company, interest earned from loans, royalties, and management fees.
The repatriated cash will significantly increase the free cash flow of the parent company. However, businesses must have access to the cash flow of their subsidiaries to take advantage of cash repatriation.
How FCF Differs from Net Income and EBITDA?
FCF differs hugely from net earnings or loss, which are used to calculate a company’s Earnings per Share (EPS) and Price-earnings (P/E) ratio. These are important numbers that indicate the value of a company’s stock.
FCF eliminates non-cash elements such as changes in inventory values, stock-based employee remuneration, and depreciation and amortisation. It only takes into account cash transactions, thus, providing a more accurate picture of how lucrative a company is. FCF can also show whether a business is tampering with its earnings by selling off assets or tampering with the value of its inventory.
Additionally, free cash flow is also different from EBITDA (Earnings before interest, taxes, depreciation, and amortisation). It is a measure of a company’s overall financial strength. However, EBITDA does not include tax payments or debt interest. In this regard, FCF can be used to compare one company’s profit-earning potential to that of a peer and expose a company’s genuine cash-generating capacity.
How to Use FCF as Part of Your Stock Selection Process?
Free Cash Flow is an important indicator to estimate the value of a firm. It is the amount of cash generated by a company that is free from all internal or external obligations; hence, it provides a better measure of a company’s performance.
A positive free cash flow indicates that the stock price of a company provides good value on the earnings per share. It also highlights the dividend-paying capacity of a company. Investors are advised to select stocks with a high P/E ratio that is comparable to the company’s FCF.
Final Word
It is evident that free cash flow is vital in determining the overall financial standing of a company. However, investors should also consider other financial measurements to determine the overall performance of a company or organisation.
FAQs
Ans: Free cash flow to equity refers to the sum of cash a firm generates that can be distributed among its shareholders. It is calculated by applying the formula: cash from operations – capital expenditure + net debt issued.
Ans: Free cash flow yield depicts whether a company’s stock price provides good value for the cash flow it generates. If you are planning to invest in dividend stocks, a yield above 4% could be somewhat acceptable. However, yields exceeding 7% are considered high ranking.
Ans: You can calculate FCFE from EBITDA by using the following formula:
FCFE = EBITDA – (Interest + Change in Net Working Capital + Taxes + Capital Expenditure) + Net Borrowing
FCFE is the amount that a company generates, which can be distributed among its shareholders.
Ans: Cash flow simply refers to the net cash flow in a business, pertaining to investing, financing and operating activities in a firm. On the other hand, you can use free cash flow to determine the current value of a firm.
Ans: Some individuals prefer calculating free cash flow after calculating the tax liabilities. However, various buyers also calculate a company’s free cash flow before tax calculation. This is primarily because their tax structure can be different from the target firm for sale.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
