# Free cash flow

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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 in legal context typically is a person —whether human or non-human—that is recognized as having certain privileges and obligations such as the legal capacity to enter into contracts, to sue, and to be sued.

## Contents

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: first, the actual decrease in value of fair value of an asset, such as the decrease in value of factory equipment each year as it is used and wears, and second, the allocation in accounting statements of the original cost of the assets to periods in which the assets are used.

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 a measure of the profitability of a venture. It is an entity's income minus cost of goods sold, expenses, depreciation & amortization, interest, 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. It is different from the gross income, which only deducts the cost of goods sold.

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.

## Calculations

Free cash flow can be calculated as follows:

ElementSource
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:

ElementSource
Net ProfitCurrent 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 ExpenseCurrent Income Statement
= Free Cash Flow

where

• Net Capital Expenditure (CAPEX) = Capex - Depreciation & Amortization
• Tax Shield = Net Interest Expense X Marginal Tax Rate

When PAT and Debt/Equity ratio is available:

ElementSource
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.

ElementSource
Net IncomeIncome Statement
+ Depreciation & AmortizationIncome Statement
- Changes in Working CapitalPrior & Current Balance Sheets
= Cash Flows from Operationssame as Statement of Cash Flows: section 1, from Operations

Therefore,

ElementData Source
Cash Flows from OperationsStatement of Cash Flows: section 1, from Operations
- Investment in operating CapitalStatement of Cash Flows: section 2, from Investment
= LeveredFree Cash Flow

## Difference with net income

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 FlowPrior period net investment spendingSpending is in current dollarsCapital investments are at the discretion of management, so spending may be sporadic.
Net IncomeDepreciation chargeCharges are smoothed, related to cumulative prior purchasesAllowing 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 makes adjustments for 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.

## Alternative formula

FCF measures:

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 symbols:

${\displaystyle FCF_{t}=OCB_{t}-I_{t}\,}$

where

• OCBt is the firm's net operating profit after taxes (Also known as NOPAT) during period t
• It is the firm's investment during period t including variation of working capital

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:

${\displaystyle I_{t}=K_{t}-K_{t-1}\,}$

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. [1]

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)

Or simply:

FCFE = FCFF + Net borrowing - Interest*(1-t)

## Uses

• 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 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 flows 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.

## Problems with capital expenditures

• The expenditures for maintenances of assets is only part of the capex 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

## Agency costs

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.

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## References

1. "Discounted Cash Flow Analysis | Street Of Walls". www.streetofwalls.com. Retrieved 2016-12-13.