Free cash flow
Encyclopedia
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.
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:
where,
When PAT and Debit/Equity ratio is available:
where d - is the debt/equity ratio. eg: For a 3:4 mix it will be 3/7.
Therefore,
There are two differences between Net Income and Free Cash Flow that should be noted. The first is the accounting for the consumption of capital goods. The Net Income measure uses depreciation, while the Free Cash Flow measure uses last period's net capital purchases.
The second difference is that the Free Cash Flow measurement deducts increases in net working capital, where the net income approach does not. Typically, in a growing company with a 30 day collection period for receivables, a 30 day payment period for purchases, and a weekly payroll, it will require more and more working capital to finance the labor and profit components embedded in the growing receivables balance. The net income measure essentially says, "You can take that cash home" because you would still have the same productive capacity as you started with. The Free Cash Flow measurement however would say, "You can't take that home" because you would cramp the enterprise from operating itself forward from there.
Likewise when a company has negative sales growth it's likely to diminish its capital spending dramatically. Receivables, provided they are being timely collected, will also ratchet down. All this "deceleration" will show up as additions to Free Cash Flow. However, over the longer term, decelerating sales trends will eventually catch up.
Net Free Cash Flow definition should also allow for cash available to pay off the company's short term debt. It should also take into account any dividends that the company means to pay.
Net Free Cash Flow = Operation Cash flow – Capital Expenses to keep current level of operation – dividends – Current Portion of long term debt – Depreciation
Here Capex Definition should not include additional investment on new equipment. However maintenance cost can be added.
Dividends - This will be base dividend that the company intends to distribute to its share holders.
Current portion of LTD - This will be minimum Debt that the company needs to pay in order to not create defaults.
Depreciation - This should be taken out since this will account for future investment for replacing the current PPE.
If the Net Income category includes the income from Discontinued operation and extraordinary income make sure it is not be part of Free Cash Flow.
Net of all the above give Free Cash available to be reinvested on operation without having to take more debt.
In symbols:
where
Investment is simply the net increase (decrease) in the firm's capital, from the end of one period to the end of the next period:
where Kt represents the firm's invested capital
at the end of period t. Increases in non-cash current asset
s may, or may not be deducted, depending on whether they are considered to be maintaining the status quo, or to be investments for growth.
Unlevered Free Cash Flow (i.e., cash flows before interest payments) is defined as EBITDA - capex - changes in net working capital - taxes. This is the generally accepted definition. If there are mandatory repayments of debt, then some analysts utilize levered free cash flow, which is the same formula above, but less interest and mandatory principal repayments.
Investment bankers compute Free Cash Flow using the following formula:
FCFF = After tax operating income + Noncash charges (such as D&A) - Capex - Working capital expenditures + Interest*(1-t)= Free Cash Flows to the Firm (FCFF)
FCFE = Net income + Noncash charges (such as D&A) - Capex - Working capital expenditures + Net Borrowing = Free Cash Flows to the equity (FCFE)
Or simply:
FCFE = FCFF + Net borrowing - Interest*(1-t)
According to the discounted cash flow
valuation model, the intrinsic value
of a company is the present value
of all future free cash flows, plus the cash proceeds from its eventual sale. The presumption is that the cash flow
s are used to pay dividends to the shareholders. Bear in mind the lumpiness discussed below.
Some investors prefer using free cash flow instead of net income
to measure a company's financial performance, because free cash flow is more difficult to manipulate than net income
. The problems with this presumption are itemized at cash flow
and return of capital
.
The payout ratio is a metric used to evaluate the sustainability of distributions from REITs, Oil and Gas Royalty Trusts, and Income Trust. The distributions are divided by the free cash flow. Distributions may include any of income, flowed-through capital gains or return of capital
.
reported on the Statement of Cash Flows. It must be separated from the expenditures for growth purposes. This split is not a requirement under GAAP
, and is not audited. Management is free to disclose maintenance capex or not. Therefore this input to the calculation of free cash flow may be subject to manipulation, or require estimation. Since it may be a large number, maintenance capex's uncertainty is the basis for some people's dismissal of 'free cash flow'.
A second problem with the maintenance capex measurement is its intrinsic 'lumpiness'. By their nature, expenditures for capital assets that will last decades may be infrequent, but costly when they occur. 'Free cash flow', in turn, will be very different from year to year. No particular year will be a 'norm' that can be expected to be repeated. For companies that have stable capital expenditures, free cash flow will (over the long term) be roughly equal to earnings
, Michael Jensen
noted that free cash flows allowed firms' managers to finance projects earning low returns which therefore might not be funded by the equity or bond markets. Examining the US oil industry, which had earned substantial free cash flows in the 1970s and the early 1980s, he wrote that
Jensen also noted a negative correlation between exploration announcements and the market valuation of these firms - the opposite effect to research announcements in other industries.
Corporate finance
Corporate finance is the area of finance dealing with monetary decisions that business enterprises make and the tools and analysis used to make these decisions. The primary goal of corporate finance is to maximize shareholder value while managing the firm's financial risks...
, free cash flow (FCF) is cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
available for distribution among all the securities holders of an organization. They include equity
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
holders, debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
holders, preferred stock
Preferred stock
Preferred stock, also called preferred shares, preference shares, or simply preferreds, is a special equity security that has properties of both an equity and a debt instrument and is generally considered a hybrid instrument...
holders, convertible security
Convertible security
A convertible security is a security that can be converted into another security. Most convertible securities are bonds or preferred stocks that pay regular quarterly interest and can be converted into shares of common stock if the stock price appreciates to a predetermined...
holders, and so on.
| Element | Data Source |
|---|---|
| EBIT Earnings before interest and taxes In accounting and finance, earnings before interest and taxes is a measure of a firm's profit that excludes interest and income tax expenses. Operating income is the difference between operating revenues and operating expenses... x (1-Tax rate) |
Current Income Statement |
| + Depreciation Depreciation Depreciation refers to two very different but related concepts:# the decrease in value of assets , and# the allocation of the cost of assets to periods in which the assets are used .... /Amortization Amortization (business) In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of intangible assets.-Amortization of loans:... |
Current Income Statement |
| - Changes in Working Capital Working capital Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is... |
Prior & Current Balance Sheets: Current Assets and Liability accounts |
| - Capital expenditure Capital expenditure Capital expenditures are expenditures creating future benefits. A capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life extending beyond the taxable year... |
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 Interest expense Interest expense relates to the cost of borrowing money. It is the price that a lender charges a borrower for the use of the lender's money. Interest expense is different from OPEX and CAPEX, for it relates to the capital structure of a company. Interest expense is usually tax-deductible.... |
Current Income Statement |
| - Net Capital Expenditure(CAPEX) | Current Income Statement |
| - Net changes in Working Capital Working capital Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is... |
Prior & Current Balance Sheets: Current Assets and Liability accounts |
| - Tax shield Tax shield A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. For example, because interest on debt is a tax-deductible expense, taking on debt creates a tax shield... on Interest Expense |
Current Income Statement |
| = Free Cash Flow |
where,
- 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 Capital expenditure Capital expenditures are expenditures creating future benefits. A capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life extending beyond the taxable year... 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 Working capital Working capital is a financial metric which represents operating liquidity available to a business, organization or other entity, including governmental entity. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Net working capital is... X (1-d) |
Balance Sheets, Cash Flow Statements |
| = Free Cash Flow |
where d - is the debt/equity ratio. eg: For a 3:4 mix it will be 3/7.
| Element | Data Source |
|---|---|
| Earning Before Interest and Tax x (1-Tax) | Current Income Statement |
| + Depreciation/Amortization | Current Income Statement |
| - Changes in Working Capital | Prior & Current Balance Sheets: Current Assets and Liability accounts |
| = Cash Flows from Operations | same as Statement of Cash Flows: section 1, from Operations |
Therefore,
| Element | Data Source |
|---|---|
| Cash Flows from Operations | Statement of Cash Flows: section 1, from Operations |
| - Capital Expenditure | Statement of Cash Flows: section 2, from Investment |
| = Free Cash Flow |
There are two differences between Net Income and Free Cash Flow that should be noted. The first is the accounting for the consumption of capital goods. The Net Income measure uses depreciation, while the Free Cash Flow measure uses last period's net capital purchases.
| Measurement Type | Component | Advantage | Disadvantage |
|---|---|---|---|
| Free Cash Flow | Prior period net investment spending | Spending is in current dollars | Capital investments are at the discretion of management, so spending may be sporadic. |
| Net Income | Depreciation charge | Charges are smoothed, related to cumulative prior purchases | Allowing for typical 2% inflation per year, equipment purchased 10 years ago for $100 would now cost about $122. With 10 year straight line depreciation the old machine would have an annual depreciation of $10, but the new, identical machine would have depreciation of $12.2, or 22% more. |
The second difference is that the Free Cash Flow measurement deducts increases in net working capital, where the net income approach does not. Typically, in a growing company with a 30 day collection period for receivables, a 30 day payment period for purchases, and a weekly payroll, it will require more and more working capital to finance the labor and profit components embedded in the growing receivables balance. The net income measure essentially says, "You can take that cash home" because you would still have the same productive capacity as you started with. The Free Cash Flow measurement however would say, "You can't take that home" because you would cramp the enterprise from operating itself forward from there.
Likewise when a company has negative sales growth it's likely to diminish its capital spending dramatically. Receivables, provided they are being timely collected, will also ratchet down. All this "deceleration" will show up as additions to Free Cash Flow. However, over the longer term, decelerating sales trends will eventually catch up.
Net Free Cash Flow definition should also allow for cash available to pay off the company's short term debt. It should also take into account any dividends that the company means to pay.
Net Free Cash Flow = Operation Cash flow – Capital Expenses to keep current level of operation – dividends – Current Portion of long term debt – Depreciation
Here Capex Definition should not include additional investment on new equipment. However maintenance cost can be added.
Dividends - This will be base dividend that the company intends to distribute to its share holders.
Current portion of LTD - This will be minimum Debt that the company needs to pay in order to not create defaults.
Depreciation - This should be taken out since this will account for future investment for replacing the current PPE.
If the Net Income category includes the income from Discontinued operation and extraordinary income make sure it is not be part of Free Cash Flow.
Net of all the above give Free Cash available to be reinvested on operation without having to take more debt.
Alternative Mathematical formula
FCF measures- operating cash flow (OCF)Operating cash flowIn financial accounting, operating cash flow , cash flow provided by operations or cash flow from operating activities , refers to the amount of cash a company generates from the revenues it brings in, excluding costs associated with long-term investment on capital items or investment in securities...
- less expenditures necessary to maintain assets (capital expenditureCapital expenditureCapital expenditures are expenditures creating future benefits. A capital expenditure is incurred when a business spends money either to buy fixed assets or to add to the value of an existing fixed asset with a useful life extending beyond the taxable year...
s or "capex")but this does not include increase in working capital. - less interest charges
In symbols:
where
- OCBt is the firm's net operating profit after taxesNOPATIn corporate finance, net operating profit after tax or NOPAT is a company's after-tax operating profit for all investors, including shareholders and debt holders. It is equal to NOPLAT and is defined as follows:An alternative formula is as follows...
(Also known as NOPAT)during period t - It is the firm's investment during period t including variation of working capital
Investment is simply the net increase (decrease) in the firm's capital, from the end of one period to the end of the next period:
where Kt represents the firm's invested capital
Invested Capital
Invested Capital represents the total cash investment that shareholders and debtholders have made in a company. There are two different but completely equivalent methods for calculating invested capital...
at the end of period t. Increases in non-cash current asset
Current asset
In accounting, a current asset is an asset on the balance sheet which can either be converted to cash or used to pay current liabilities within 12 months...
s may, or may not be deducted, depending on whether they are considered to be maintaining the status quo, or to be investments for growth.
Unlevered Free Cash Flow (i.e., cash flows before interest payments) is defined as EBITDA - capex - changes in net working capital - taxes. This is the generally accepted definition. If there are mandatory repayments of debt, then some analysts utilize levered free cash flow, which is the same formula above, but less interest and mandatory principal repayments.
Investment bankers compute Free Cash Flow using the following formula:
FCFF = After tax operating income + Noncash charges (such as D&A) - Capex - Working capital expenditures + Interest*(1-t)= Free Cash Flows to the Firm (FCFF)
FCFE = Net income + Noncash charges (such as D&A) - Capex - Working capital expenditures + Net Borrowing = Free Cash Flows to the equity (FCFE)
Or simply:
FCFE = FCFF + Net borrowing - Interest*(1-t)
Uses of the metric
Free cash flow measures the ease with which businesses can grow and pay dividends to shareholders. Even profitable businesses may have negative cash flows. Their requirement for increased financing will result in increased financing cost reducing future income.According to the discounted cash flow
Discounted cash flow
In finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
valuation model, the intrinsic value
Intrinsic value
Intrinsic value can refer to:*Intrinsic value , of an option or stock.*Intrinsic value , of a coin.*Intrinsic value , in ethics and philosophy.*Intrinsic value , in philosophy....
of a company is the present value
Present value
Present value, also known as present discounted value, is the value on a given date of a future payment or series of future payments, discounted to reflect the time value of money and other factors such as investment risk...
of all future free cash flows, plus the cash proceeds from its eventual sale. The presumption is that the cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
s are used to pay dividends to the shareholders. Bear in mind the lumpiness discussed below.
Some investors prefer using free cash flow instead of net income
Net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
to measure a company's financial performance, because free cash flow is more difficult to manipulate than net income
Net income
Net income is the residual income of a firm after adding total revenue and gains and subtracting all expenses and losses for the reporting period. Net income can be distributed among holders of common stock as a dividend or held by the firm as an addition to retained earnings...
. The problems with this presumption are itemized at cash flow
Cash flow
Cash flow is the movement of money into or out of a business, project, or financial product. It is usually measured during a specified, finite period of time. Measurement of cash flow can be used for calculating other parameters that give information on a company's value and situation.Cash flow...
and return of capital
Return of capital
Return of capital refers to payments back to "capital owners" that exceed the growth of a business. It should not be confused with return on capital which measures a 'rate of return'....
.
The payout ratio is a metric used to evaluate the sustainability of distributions from REITs, Oil and Gas Royalty Trusts, and Income Trust. The distributions are divided by the free cash flow. Distributions may include any of income, flowed-through capital gains or return of capital
Return of capital
Return of capital refers to payments back to "capital owners" that exceed the growth of a business. It should not be confused with return on capital which measures a 'rate of return'....
.
Problems with capital expenditures
The expenditures for maintenances of assets is only part of the capexCAPEX
CAPEX, also known as the Kerala State Cashew Workers Apex Industrial Co-operative Society, is an organization managed by the government of Kerala to promote the cashew industry and especially the export market for cashews.-Organization:...
reported on the Statement of Cash Flows. It must be separated from the expenditures for growth purposes. This split is not a requirement under GAAP
Gaap
In demonology, Gaap is a mighty Prince and Great President of Hell, commanding sixty-six legions of demons. He is, according to The Lesser Key of Solomon, the king and prince of the southern region of Hell and Earth, and according to the Pseudomonarchia Daemonum the king of the western region and...
, and is not audited. Management is free to disclose maintenance capex or not. Therefore this input to the calculation of free cash flow may be subject to manipulation, or require estimation. Since it may be a large number, maintenance capex's uncertainty is the basis for some people's dismissal of 'free cash flow'.
A second problem with the maintenance capex measurement is its intrinsic 'lumpiness'. By their nature, expenditures for capital assets that will last decades may be infrequent, but costly when they occur. 'Free cash flow', in turn, will be very different from year to year. No particular year will be a 'norm' that can be expected to be repeated. For companies that have stable capital expenditures, free cash flow will (over the long term) be roughly equal to earnings
Agency costs of free cash flow
In a 1986 paper in the American Economic ReviewAmerican Economic Review
The American Economic Review is a peer-reviewed academic journal of economics publishing seven issues annually by the American Economic Association. First published in 1911, it is considered one of the most prestigious journals in the field. The current editor-in-chief is Penny Goldberg . The...
, Michael Jensen
Michael Jensen
Michael Cole "Mike" Jensen is an American economist working in the area of financial economics. He is currently the managing director in charge of organizational strategy at Monitor Group, a strategy consulting firm, and the Jesse Isidor Straus Professor of Business Administration, Emeritus at...
noted that free cash flows allowed firms' managers to finance projects earning low returns which therefore might not be funded by the equity or bond markets. Examining the US oil industry, which had earned substantial free cash flows in the 1970s and the early 1980s, he wrote that
[the] 1984 cash flows of the ten largest oil companies were $48.5 billion, 28 percent of the total cash flows of the top 200 firms in Dun's Business Month survey. Consistent with the agency costs of free cash flow, management did not pay out the excess resources to shareholders. Instead, the industry continued to spend heavily on [exploration and development] activity even though average returns were below the cost of capital.
Jensen also noted a negative correlation between exploration announcements and the market valuation of these firms - the opposite effect to research announcements in other industries.
See also
- Business valuationBusiness valuationBusiness valuation is a process and a set of procedures used to estimate the economic value of an owner’s interest in a business. Valuation is used by financial market participants to determine the price they are willing to pay or receive to consummate a sale of a business...
- Discounted cash flowDiscounted cash flowIn finance, discounted cash flow analysis is a method of valuing a project, company, or asset using the concepts of the time value of money...
- Enterprise valueEnterprise valueEnterprise value , Total enterprise value , or Firm value is an economic measure reflecting the market value of a whole business. It is a sum of claims of all the security-holders: debtholders, preferred shareholders, minority shareholders, common equity holders, and others...
- Economic value addedEconomic value addedIn corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors . Quite simply, EVA is the profit earned by the firm less the cost of...
- Owner earningsOwner earningsIn 1986, Warren Buffett detailed his valuation method. He stated that the value of a company is simply the total of the net cash flows expected to occur over the life of the business, discounted by an appropriate interest rate....
- Weighted average cost of capitalWeighted average cost of capitalThe weighted average cost of capital is the rate that a company is expected to pay on average to all its security holders to finance its assets....
External links
- Free Cash Flow: Free, But Not Always Easy, Investopedia
- What is Free Cash Flow?, Morningstar