Even a non-specialist can understand what someone is referring to when they use the term cash flow. Cash flows have been the basis of identifying a business from aeons.
In corporate finance, FCF, or Free cash flow, represents the amount by which a business’s cash flow from operations exceeds its working capital requirements and capital expenditures.
Free cash flow includes capital expenditures such as spending on pieces of equipment and assets and changes in working capital. Still, it excludes non-cash expenses from the Profit and Loss Statement.
In most cases, analysts and investors use free cash flow to evaluate a company’s performance as a measure of profitability instead of EPS (Earnings per share).
Free cash flow tends to facilitate decision-making in a company. The value of free cash flow can help decide whether the company wants to expand its business or pay a dividend on the shares. Expansion of business is also beneficial for the shareholder value.
As a result of free cash, a company can also settle its leverage.
Free cash flow is a crucial metric. It allows an investor to analyse the future potential of a company to generate profits with more transparency than earnings per share.
Companies with higher free cash flow values look more promising than other companies. It portrays free cash flow as an essential basis for stock pricing. But what makes free cash flow so crucial? To know that, we need to dive into the details.
Free cash flow represents the cash available with the company to repay its creditors or payout interests and dividends to its investors. Generally, it is calculated by deducting capital expenditure from operating cash flow.
The standard formula for calculating free cash flow is:
Free cash flow = Operating cash flow – Capital expenditure.
For a better understanding, let us analyse free cash flow with the help of an example.
Let us assume a company named Aika Limited published its cash flow statement for the financial year ending 2021.
The accounting statement of Aika Limited states that:
Cash Flow From Operating Activities = INR 10,000 crores
Capital Expenditures = INR 3,500 crores.
We are required to calculate the free cash flow of the company.
Now, we already know that,
Operating cash flow of Aika Limited = 10,000 crores
and,
Capital expenditure of Aika Limited = 3,500 crores.
The formula for free cash flow:
Free cash flow = Operating cash flow – Capital expenditure
Free cash flow = INR 10,000 crores – INR 3,500 crores
Free cash flow = INR 6,500 crores.
Interpretation
Aika Limited has a free cash flow of INR 6,500 crores, which means it has INR 6,500 crores remaining after paying its capital expenditures. Aika Limited can use this money to pay dividends or debts, and they can also use it to expand their business.
Different companies have different accounting fundamentals. Hence, there are various ways to calculate free cash flows.
Irrespective of the method used to calculate free cash flow, the end value will be the same for the given information.
There are three ways to calculate free cash flow. The methodologies involve calculating free cash flow by using operating cash flow, sales revenue, and net operating profits after tax.
Let us understand how to calculate free cash flow by using each one of them.
The most common method of calculating free cash flow is operating cash flow, and it is the simplest method, involving only two components: operating cash flow and capital expenditure. To determine the free cash flow value, one must deduct capital expenditure from operating cash flow.
The formula for calculating free cash flow using operating cash flow is:
Free cash flow = Operating cash flow – Capital Expenditure.
Calculating free cash flow by using sales revenue means adding the income earned by a company through its core operations and then deducting the total cost incurred to carry out those operations.
This method is used to calculate free cash flow when the income statement and balance sheet are the primary sources of information.
The formula for calculating free cash flow using sales revenue is:
Free cash flow = Sales Revenue – (Operating Costs + Taxes ) – investments required in operating capital.
Where,
Investments required in operating capital = Total net operating capital of 1st year – total net operating capital of 2nd year.
Now, Total net operating capital = Net operating working capital + Net plant, property and equipment (operating long-term assets).
Further, Net operating working capital = Operating current assets – Operating current liabilities.
And, Operating current assets comprise cash, account receivables and inventories, while current operating liabilities include account payables and accrued payments.
We find that it is similar to calculating sales revenue during the free cash flow analysis by using net operating profit after tax. But, in this method, operating income is used instead of sales revenue.
The formula for calculating free cash flow using net operating profits after tax is:
Free cash flow = Net operating profit after taxes – Net investment in the operating capital.
Where,
Net operating profit after taxes = Operating income X (1 – tax rate )
Now, Operating income = Gross profit – Operating expenses.
Free cash flow is a professional financial tool for analysing a company’s profitability, liquidity, and efficiency.
A movement in free cash flow value often indicates the firm’s performance, and the performance may be positive or negative depending upon the change.
Let us understand the significance behind changing values of free cash flow.
There can be many reasons behind an increase in the value of free cash flow, and these reasons are an indicator of the company’s performance. Here is a list of reasons behind increased free cash flow.
A decrease in the value of cash-free flow could be because of the following reasons:
The free cash flow can be categorised into two types:
Free cash flow to the firm is a metric to gauge the ability of a firm to generate cash by factoring in its capital expenditure.
Free cash flow to the firm is also known as unlevered free cash flow. The calculation of this metric is facilitated through cash flow generated from operations.
Instead of cash flow generated from operations, an individual can also use the net income of the organisation to calculate free cash flow for the firm (FCFF).
The formula used for calculating free cash flow to the firm:
Free cash flow to the firm = Cash flow generated from operating activities – capital expenditure
Or
Free cash flow to the firm = Net earnings – capital expenditure.
Also known as levered cash flow, free cash flow to equity determines the money a company can distribute as dividends to its equity shareholders.
If all the reinvestments are taken care of along with payment of all expenses and debt, a company might also use free cash flow to equity for share buybacks.
But, overall, free cash flow to equity (FCFE) is the free cash flow available for equity shareholders after deducting the tax on the interest amount.
The formula used for calculating free cash flow to equity (FCFE) is as follows:
Free cash flow to equity = free cash flow to the firm + Net borrowing – Interest amount*(1-tax).
Free cash flow is beneficial for various parties like investors, creditors and partners. To provide a better understanding, we have listed the merits of Free cash flow for each party.
Creditors are the ones who provide substantial capital to businesses for their ventures. They are lending considerable wealth at times, and it can be risky. Therefore, creditors like to stay aware of specific figures. The free cash flow provides those figures to the creditors. It is a tool used by creditors to analyse the repayment capabilities of any company.
After analysing the repayment capabilities of a company through free cash flow, the creditors can then decide with ease whether they want to sanction a loan amount to a particular company or not.
If someone is looking for a business partner, they often look for entities skilled at having enough earnings to sustain themselves.
The free cash flow helps individuals analyse a company’s operations before deciding on their partnership business model. A company with better free cash flow is always preferred over others.
Now, let us look at the flip side of free cash flow. There are certain restrictions when it comes to free cash flow, and the demerits are as follows:
If one wants to calculate free cash flow with the help of depreciation and amortisation, then one needs to add them back to the net income.
Sometimes, additional changes are made in working capital by subtracting current liabilities from current assets.
The formula for calculating free cash flow with depreciation and amortisation is:
Free cash flow = Net cash flow + Depreciation/Amortisation – (current assets – current liabilities) – capital expenditure.
One might ask why we add back depreciation and amortisation when they are capital expenses.
The primary purpose of adding depreciation and amortisation is to look at current cash spending instead of past transactions.
The judgement makes free cash flow a crucial instrument for identifying potential companies with high upfront costs.
Note: Upfront costs can severely reduce earnings currently but can contribute to substantial future growth in a company.
Final thoughts
Free cash flow is a crucial metric for analysing the financial stability of a company. It informs an individual about the cash funds left in a company after accounting for the operating and capital expenditures.
A higher free cash flow indicates a robust company with a better financial position. The company can distribute its free cash flow to the shareholders by paying dividends, and it can also reduce the debt by repaying the creditors with free cash flow.
Free cash flow is also said to deliver more transparent results than earnings per share.
Free cash flow is not an exclusive term in the financial statement, and it is not listed on a stand-alone basis.
However, suppose you still want to derive the three cash flows from the financial statements. You can calculate it by finding capital expenditure on the cash flow statement and deducting it from the operating cash flow in the same statement.
The free cash flow rate is a metric used to find out if the stock price of a company provides good value for the free cash flow.
An investor planning to invest in dividend stock looks for free cash flow yields above 4 per cent. Stocks with free cash flow yields below 4% are generally termed poor investments.
If the Free cash flow yield for a stock is above 7%, it is termed investment appropriate stock
Yes, free cash flow is a crucial metric for analysing a company's profitability. A company with a negative free cash flow might have to raise funds to maintain its solvency.
And a company with a free cash flow value that is satisfactory enough to run its operations but not enough for expansion might face difficulty while competing with its competitors.
The net cash flow is a measure of the total cash generated by the company through operating activities, investing activities, and financing activities.
If the cash inflow is more than the cash outflow, the net cash flow is positive. Similarly, if the cash outflow is more than the cash inflow, the net cash flow is negative.
However, free cash flow is a measure of the cash generated by a company through its operating activities after deducting capital and operating expenditures.
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