Free cash flow or FCF refers to the cash a firm gives rise to after accounting for financial outflows to strengthen operations and maintain its funds. Unlike earnings or net income, free cash flow is a measure of profitability that removes the income statement’s non-cash items and includes spending on equipment and assets, as well as changes in working capital.
The widely accepted notion of free cash flow excludes interest payments. Investment bankers and analysts will utilize free cash flow variants such as free cash flow for the firm and free cash flow to equity, which are adjusted for payments interest, and borrowings, to estimate a company’s performance with different capital arrangements.
Understanding the Concept of Free Cash Flow (FCF)
The cash flow available for the company to repay creditors or pay dividends and interest to investors is known as free cash flow (FCF). Because it excludes non-cash items from the income statement, some investors favor FCF or FCF per share as a measure of profitability over earnings or earnings per share. FCF, on the other hand, can be lumpy and uneven over time because it accounts for investments in property, plants, and equipment.
The Advantages of Free Cash Flow (FCF)
FCF can provide key insights into a company’s worth and the health of its basic trends because it accounts for changes in working capital. A dip in accounts payable could indicate that vendors are wanting fast payment. A drop in accounts receivable (inflow) could indicate that the company is collecting money from clients more quickly. A rise in inventory (outflow) could signal a growing hoard of unsold goods. Working capital is included in a measure of profitability because it provides information not seen in the income statement.
Free cash flow can also be used as an initial point for potential investors or to determine if the company will be able to pay estimated dividends or interest. A lender would get a better impression of the quality of cash flows available for borrowings if the organization’s debt payments were eliminated from Free Cash Flow to the Firm. Similarly, shareholders can consider the predicted stability of future dividend payments by subtracting FCF from interest payments.
Limitation of Free Cash Flow
Consider a corporation that earns $1,000,000 in profits before depreciation, amortization, interest, and taxes (EBITDA) in a given year. Assume that this company’s working capital (current assets minus current liabilities) has remained unchanged. But that they purchased new equipment worth $800,000 at the end of the year. The cost of the new equipment will be spread out over time through depreciation on the income statement, resulting in a more even impact on earnings.
Because FCF accounts for cash spent on new equipment in the current year, the company will report $200,000 in FCF ($1,000,000 EBITDA – $800,000 Equipment) on $1,000,000 in EBITDA. EBITDA and FCF will be equal again the next year, assuming everything else stays the same and no new equipment is purchased. In this case, an investor must figure out why FCF dropped so sharply one year before returning to former levels, and whether the trend is likely to continue.
How is Free Cash Flow calculated?
FCF can be calculated using one of two methods. The first method starts with Cash Flow from Operating Activities (CFOA). Then adjusts for interest expense, the tax shield on interest expense, and any capital expenditures (CAPEX) made that year. The second method starts with Earnings Before Interest and Taxes (EBIT). Then adjusts for income taxes, non-cash items such depreciation and amortization, working capital changes, and CAPEX. The resulting numbers should be equivalent in both, but depending on the data provided, one strategy is favored over the other.