In corporate finance, free cash flow (FCF) or free cash flow to firm (FCFF) is a way of looking at a business's cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, and convertible security holders when they want to see how much cash can be extracted from a company without causing issues to its operations.
Corporate finance is an area of finance that deals with sources of funding, the capital structure of corporations, the actions that managers take to increase the value of the firm to the shareholders, and the tools and analysis used to allocate financial resources. The primary goal of corporate finance is to maximize or increase shareholder value. Although it is in principle different from managerial finance which studies the financial management of all firms, rather than corporations alone, the main concepts in the study of corporate finance are applicable to the financial problems of all kinds of firms.
A cash flow is a real or virtual movement of money:
A legal person is any human or non-human entity, in other words, any human being, firm, or government agency that is recognized as having privileges and obligations, such as having the ability to enter into contracts, to sue, and to be sued.
Free cash flow can be calculated in various ways, depending on audience and available data. A common measure is to take the earnings before interest and taxes multiplied by (1 − tax rate), add depreciation and amortization, and then subtract changes in working capital and capital expenditure. Depending on the audience, a number of refinements and adjustments may also be made to try to eliminate distortions.
In accounting and finance, earnings before interest and taxes (EBIT) is a measure of a firm's profit that includes all incomes and expenses except interest expenses and income tax expenses.
In accountancy, depreciation refers to two aspects of the same concept:
In business, amortization refers to spreading payments over multiple periods. The term is used for two separate processes: amortization of loans and amortization of assets. In the latter case it refers to allocating the cost of an intangible asset over a period of time.
Free cash flow may be different from net income, as free cash flow takes into account the purchase of capital goods and changes in working capital.
In business and accounting, net income is an entity's income minus cost of goods sold, expenses and taxes for an accounting period. It is computed as the residual of all revenues and gains over all expenses and losses for the period, and has also been defined as the net increase in shareholders' equity that results from a company's operations. In the context of the presentation of financial statements, the IFRS Foundation defines net income as synonymous with profit and loss. The difference between revenue and the cost of making a product or providing a service, before deducting overheads, payroll, taxation, and interest payments. This is different from operating profit.
A capital good is a durable good that is used in the production of goods or services. Capital goods are one of the three types of producer goods, the other two being land and labour. The three are also known collectively as "primary factors of production"
Working capital is a financial metric which represents operating liquidity available to a business, organisation or other entity, including governmental entities. Along with fixed assets such as plant and equipment, working capital is considered a part of operating capital. Gross working capital is equal to current assets. Working capital is calculated as current assets minus current liabilities. If current assets are less than current liabilities, an entity has a working capital deficiency, also called a working capital deficit.
Free cash flow can be calculated as follows:
|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 (CAPEX)||Prior & Current Balance Sheets: Property, Plant and Equipment accounts|
|= Free Cash Flow|
Note that the first three lines above are calculated on the standard Statement of Cash Flows.
When net profit and tax rate applicable are given, you can also calculate it by taking:
|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|
When PAT and Debt/Equity ratio is available:
|Profit after Tax (PAT)||Income Statement|
|- Changes in Capital expenditure X (1-d)||Balance Sheets, Cash Flow Statements|
|+ Depreciation & Amortization X (1-d)||Prior & Current Balance Sheets|
|- Changes in Working Capital X (1-d)||Balance Sheets, Cash Flow Statements|
|= Free Cash Flow|
where d - is the debt/equity ratio. e.g.: For a 3:4 mix it will be 3/7.
|Net Income||Income Statement|
|+ Depreciation & Amortization||Income Statement|
|- Changes in Working Capital||Prior & Current Balance Sheets|
|= Cash Flows from Operations||same as Statement of Cash Flows: section 1, from Operations|
|Cash Flows from Operations||Statement of Cash Flows: section 1, from Operations|
|- Investment in operating Capital||Statement of Cash Flows: section 2, from Investment|
|= LeveredFree Cash Flow|
There are two differences between net income and free cash flow. The first is the accounting for the purchase of capital goods. Net income deducts depreciation, while the free cash flow measure uses last period's net capital purchases.
|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 adjusts changes 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 working capital to finance the labor and profit components embedded in the growing receivables balance.
When a company has negative sales growth, it's likely to lower its capital spending. 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 long 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 default.
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 part of Free Cash Flow.
Net of all the above give free cash available to be reinvested in operations without having to take more debt.
In financial accounting, operating cash flow (OCF), cash flow provided by operations, cash flow from operating activities (CFO) or free cash flow from operations (FCFO), 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. The International Financial Reporting Standards defines operating cash flow as cash generated from operations less taxation and interest paid, investment income received and less dividends paid gives rise to operating cash flows. To calculate cash generated from operations, one must calculate cash generated from customers and cash paid to suppliers. The difference between the two reflects cash generated from operations.
Capital expenditure or capital expense is the money a company spends to buy, maintain, or improve its fixed assets, such as buildings, vehicles, equipment, or land. It is considered a capital expenditure when the asset is newly purchased or when money is used towards extending the useful life of an existing asset, such as repairing the roof.
In corporate finance, net operating profit after tax (NOPAT) is a company's after-tax operating profit for all investors, including shareholders and debt holders. NOPAT is used by analysts and investors as a precise and accurate measurement of profitability to compare a company's financial results across its history and against competitors.
When calculating NOPAT, one removes Interest Expense and the effects of other non-operating activities from Net Income to arrive at a value that approximates the value of a firm's annual earnings. NOPAT is precisely calculated as:
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 assets 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. The unlevered cash flow (UFCF) is usually used as the industry norm, because it allows for easier comparison of different companies’ cash flows. It is also preferred over the levered cash flow when conducting analyses to test the impact of different capital structures on the company.
Investment bankers compute free cash flow using the following formulae:
FCFF = After tax operating income + Noncash charges (such as D&A) - CAPEX - Working capital expenditures = Free cash flow to firm (FCFF)
FCFE = Net income + Noncash charges (such as D&A) - CAPEX - Change in non-cash working capital + Net borrowing = Free cash flow to equity (FCFE)
FCFE = FCFF + Net borrowing - Interest*(1-t)
In a 1986 paper in the American Economic Review , 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:
[the] 1984 cash flows of the ten largest oil companies were $48.5 billion, 28 percent of the total cash flows of the top 200 firms in Dun's Business Month survey. Consistent with the agency costs of free cash flow, management did not pay out the excess resources to shareholders. Instead, the industry continued to spend heavily on [exploration and development] activity even though average returns were below the cost of capital.
Jensen also noted a negative correlation between exploration announcements and the market valuation of these firms—the opposite effect to research announcements in other industries.
Finance is a field that is concerned with the allocation (investment) of assets and liabilities over space and time, often under conditions of risk or uncertainty. Finance can also be defined as the art of money management. Participants in the market aim to price assets based on their risk level, fundamental value, and their expected rate of return. Finance can be split into three sub-categories: public finance, corporate finance and personal finance.
In corporate finance, as part of fundamental analysis, economic value added (EVA) is an estimate of a firm's economic profit, or the value created in excess of the required return of the company's shareholders. EVA is the net profit less the capital charge ($) for raising the firm's capital. The idea is that value is created when the return on the firm's economic capital employed exceeds the cost of that capital. This amount can be determined by making adjustments to GAAP accounting. There are potentially over 160 adjustments but in practice only several key ones are made, depending on the company and its industry. EVA is a service mark of Stern Value Management.
A company's earnings before interest, taxes, depreciation, and amortization is an accounting measure calculated using a company's net earnings, before interest expenses, taxes, depreciation, and amortization are subtracted, as a proxy for a company's current operating profitability.
The APV was introduced by the italian mathematician Lorenzo Peccati, Professor at the Bocconi University. The method is to calculate the NPV of the project as if it is all-equity financed. Then the base-case NPV is adjusted for the benefits of financing. Usually, the main benefit is a tax shield resulted from tax deductibility of interest payments. Another benefit can be a subsidized borrowing at sub-market rates. The APV method is especially effective when a leveraged buyout case is considered since the company is loaded with an extreme amount of debt, so the tax shield is substantial.
In financial accounting, a cash flow statement, also known as statement of cash flows, is a financial statement that shows how changes in balance sheet accounts and income affect cash and cash equivalents, and breaks the analysis down to operating, investing, and financing activities. Essentially, the cash flow statement is concerned with the flow of cash in and out of the business. The statement captures both the current operating results and the accompanying changes in the balance sheet. As an analytical tool, the statement of cash flows is useful in determining the short-term viability of a company, particularly its ability to pay bills. International Accounting Standard 7, is the International Accounting Standard that deals with cash flow statements.
In economics and accounting, the cost of capital is the cost of a company's funds, or, from an investor's point of view "the required rate of return on a portfolio company's existing securities". It is used to evaluate new projects of a company. It is the minimum return that investors expect for providing capital to the company, thus setting a benchmark that a new project has to meet.
Return on capital (ROC), or return on invested capital (ROIC), is a ratio used in finance, valuation and accounting, as a measure of the profitability and value-creating potential of companies after taking into account the amount of initial capital invested. The ratio is calculated by dividing the after-tax operating income (NOPAT) by the book value of both debt and equity capital less cash/equivalents.
Return of capital (ROC) refers to principal payments back to "capital owners" that exceed the growth of a business or investment. It should not be confused with Rate of Return (ROR), which measures a gain or loss on an investment. Basically, it is a return of some or all of the initial investment, which reduces the basis on that investment.
Valuation using discounted cash flows is a method for determining the current value of a company using future cash flows adjusted for time value of money. The future cash flow set is made up of the cash flows within the determined forecast period and a continuing value that represents the cash flow stream after the forecast period. Discounted Cash Flow valuation was used in industry as early as the 1700s or 1800s, widely discussed in financial economics in the 1960s, and became widely used in U.S. Courts in the 1980s and 1990s.
The debt service coverage ratio (DSCR), also known as "debt coverage ratio" (DCR), is the ratio of cash available to debt servicing for interest, principal and lease payments. It is a popular benchmark used in the measurement of an entity's ability to produce enough cash to cover its debt payments. The higher this ratio is, the easier it is to obtain a loan. The phrase is also used in commercial banking and may be expressed as a minimum ratio that is acceptable to a lender; it may be a loan condition. Breaching a DSCR covenant can, in some circumstances, be an act of default.
Financial management focuses on ratios, equities and debts. It is useful for portfolio management,distribution of dividend,capital raising,hedging and looking after fluctuations in foreign currency and product cycles.Financial managers are the people who will do research and based on the research, decide what sort of capital to obtain in order to fund the company's assets as well as maximizing the value of the firm for all the stakeholders. It also refers to the efficient and effective management of money (funds) in such a manner as to accomplish the objectives of the organization. It is the specialized function directly associated with the top management. The significance of this function is not seen in the 'Line' but also in the capacity of the 'Staff' in overall of a company. It has been defined differently by different experts in the field.
Project finance is only possible when the project is capable of producing enough cash to cover all operating and debt-servicing expenses over the whole tenor of the debt. A financial model is needed to assess economic feasibility of the project.
Strategic financial management is the study of finance with a long term view considering the strategic goals of the enterprise. Financial management is nowadays increasingly referred to as "Strategic Financial Management" so as to give it an increased frame of reference.
A financial ratio or accounting ratio is a relative magnitude of two selected numerical values taken from an enterprise's financial statements. Often used in accounting, there are many standard ratios used to try to evaluate the overall financial condition of a corporation or other organization. Financial ratios may be used by managers within a firm, by current and potential shareholders (owners) of a firm, and by a firm's creditors. Financial analysts use financial ratios to compare the strengths and weaknesses in various companies. If shares in a company are traded in a financial market, the market price of the shares is used in certain financial ratios.
In business accounting, the statement of change in financial position is a financial statement that outlines the sources and uses of funds and explains any changes in cash or working capital.
In corporate finance, free cash flow to equity (FCFE) is a metric of how much cash can be distributed to the equity shareholders of the company as dividends or stock buybacks—after all expenses, reinvestments, and debt repayments are taken care of. Whereas dividends are the cash flows actually paid to shareholders, the FCFE is the cash flow simply available to shareholders. The FCFE is usually calculated as a part of DCF or LBO modelling and valuation. The FCFE is also called the levered free cash flow.