In corporate finance, free cash flow (FCF) is cash flow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on. G. Bennett Stewart - the "economic model of value holds that share prices are determined by just two things: the cash to be generated over the lifetime of a business and the risk of the cash receipts”. GSB (1990), “The Quest for Value”
FCF is the cashflow generated by a company’s operations that is free, or net, of the new capital invested for growth. Imagine all a company’s cash receipts are deposited in a cigar box, and that all of its cash operating outlays are taken out, regardless of whether they are capital expenditures on balance sheet or on income statement as expenses (where cash outflows are recorded makes no difference, unless it affects taxes). What’s left over is FCF. Sales revenue| X|
Less: Operating costs| (X)|
Operating profit| X|
Add: depreciation| X|
Less: cash tax| (X)|
Operating cash flow| X|
Less: investment in fixed assets | (X)|
Less: investment (change) in working capital| (X)|
Free Cash Flow| X|
Value does not necessarily equal FCF, although a firm with high FCF is usually creating value for investors.
FCF depends also on the expected rate of return on new investments that the company is making.
A word of caution - a profitable company spending lots of new capital expenditures to expand might have a negative (temporary) FCF. Whereas a company selling assets to pay creditors might have a positive FCF! The answer to which company is creating greater value is actually the company with the negative FCF in this case.
So FCF must be measured over the lifetime of the business, not just in any one period: a +ve or –ve FCF cannot be judged without examining the quality of FCF – ie. The rate of return on the investments.
Most companies earnings and FCF move together – positive correlation. Also a positive correlation on companies stock prices, which respond proportionately (mostly) to changes in earnings or FCF.
Accounting entries that do not affect cash – such as amoritsation of goodwill on the balance sheet, for example, do not affect value. What matters is how much cash is paid for the acquisition, and how much cash is likely to flow in afterwards.
Element| Data Source|
EBIT x (1-Tax rate)| Current Income Statement|
+ Depreciation/Amortization| Current Income Statement|
- Changes in Working Capital| Prior & Current Balance Sheets: Current Assets and Liability accounts| - Capital expenditure| Prior & Current Balance Sheets: Property, Plant and Equipment accounts| = Free Cash Flow| |
Note that the first three lines above are calculated for you on the standard Statement of Cash Flows.
When Net profit and Tax rate applicable are given, you can also calculate it by taking: Element| Data Source|
Net Profit| Current Income Statement|
+ Interest expense| Current Income Statement|
- Net Capital Expenditure(CAPEX)| Current Income Statement| - Net changes in Working Capital| Prior & Current Balance Sheets: Current Assets and Liability accounts| - Tax shield on Interest Expense| Current Income Statement| = Free Cash Flow| |
* Net Capital Expenditure(CAPEX) = Capex - Depreciation & Amortization * Tax Shield = Net Interest Expense X Effective Tax Rate
When PAT and Debit/Equity ratio is available:
Element| Data Source|
Profit after Tax (PAT)| Current Income Statement|
- Changes in Capital expenditure X (1-d)| Balance Sheets, Cash Flow Statements| + Depreciation/Amortization X (1-d)| Prior & Current Balance Sheets: Current Assets and Liability accounts| - Changes in Working Capital X (1-d)| Balance Sheets, Cash Flow Statements| = Free Cash Flow| |
where d - is the debt/equity ratio. eg: For a...