Free Cash Flow
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.
| Element | Data Source |
|---|---|
| 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 | 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 | 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 |
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 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 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.
| 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: 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.
Read more about Free Cash Flow: Alternative Mathematical Formula, Uses of The Metric, Problems With Capital Expenditures, Agency Costs of Free Cash Flow
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