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Free Cash Flow, generally abbreviated as FCF, is an essential measure of cash a company generates after fulfilling all the company expenses, including operational costs, capital expenditures, and working capital.
FCF can help the investors to determine the financial health of the company. In this article, we’ve discussed everything you must know about free cash flow. Let’s begin the guide !!
What is Free Cash Flow (FCF)?
Free Cash Flow (FCF) refers to the amount left after maintaining the overhead expenses and capital expenditures. In simple words, FCF is the remaining money after paying for essential items like payroll, rent, and taxes. This additional cash can be used to repay creditors or reward investors with interest and dividends.
Positive free cash flow indicates that the company has generated more cash than required to manage operating costs. In contrast, a negative free cash flow figure indicates that the company is left with zero money after fulfilling the overheads. It directly showcases how efficiently or inefficiently a company generates and manages essential costs and expenses.
Types of Free Cash Flow
There are basically two types of FCF, mentioned below:
1. Free Cash Flow to Firm (FCFF)
FCFF is used to demonstrate the company’s ability to generate cash after deducting all the capital expenses. The positive value signals the available cash, while the negative signals no money left. You can calculate it by using the cash flow from operations or the company’s net Income.
Here’s the required computational free cash flow to the firm formula:
FCFF = Cash Flow from Operating Activity (CFO) – Capital Expenditure (CAPEX)
2. Free Cash Flow to Equity (FCFE)
As the name suggests, FCFE refers to the cash available for the company’s equity investors. The amount is used for the distribution of dividends and stock buybacks to the company’s equity owners after managing all the payments related to costs, investments, and debt.
Here’s the required computational formula:
FCFE = FCFF + Net Borrowing – Interest Amount*(1-tax)
Importance of Free Cash Flow
Free Cash Flow demonstrates the financial health of the company by measuring its grounds. It will help you highlight the potential for future growth and business expansion.
Below, we’ve mentioned several measures indicating the free cash flow importance.
1. Boost the Company’s Growth
Only a company with sufficient FCF can look for steady growth. It can form new goods, pay off debt, provide dividends, and look for a potential business prospect. Hence, companies must aim to have a greater FCF to have immense corporate growth.
2. Precision in Financial Health
As compared to net income and earnings per share, Free Cash Flow precisely showcases the company’s financial health by involving real cash flow.
3. Help Investors to Make Decisions
Investors generally look for small companies with steady and predictable growth. FCF helps the theme identify the ongoing condition of the company. Plus, verifying this metric will increase their chances of making a high return on investment.
4. Estimate the Company’s Performance
Free Cash Flow can help you evaluate the existing performance and growth of the company. If a company has a positive FCF and pays consistent dividends, it directly showcases the actual performance of the company. It can also help you identify the business profitability.
These are the major benefits of the Free Cash Flow. Every company or business must know how to calculate free cash flow. In the next section, it is clearly and cohesively mentioned.
How to Calculate Free Cash Flow (FCF)?
Free Cash Flow (FCF) can easily be calculated by using the company’s income statement and balance sheet.
Free Cash Flow = Net Income + Non-Cash Items + Chances in Working Capital
Where,
Net Income = It refers to the amount a company generates after fulfilling all of its expenditures.
Non-Cash Items = It refers to the items like depreciation and amortization. These additional costs are generally associated with assets like buildings and equipment that are spread out over certain years.
Changes in Working Capital = It is the difference between the company’s current assets and current liabilities.
Here, a positive figure showcases that the company has used more cash for the repayment of debt and the purchase of new assets. The negative figure showcases that the company has spent more money than it has.
How to Calculate Free Cash Flow Using Operating Cash Flow?
If you have the operational cash flow details, you can easily compute the Free Cash Flow. You just have to subtract the capital expenditure (any investment in buildings or new equipment) from the cash flow.
Here’s a computational formula for the free cash flow:
Free Cash Flow = Operating cash flow – Capital expenditure
However, before proceeding to the formula, you must calculate the net investment figure. Below is a simple formula.
Net investment figure = Total capital expenditure on current assets – minus the cost of depreciation
The free cash flow figure indicates the amount of money a company has after fulfilling its operations and investments. Companies use this money to repay debt, develop growth initiatives, or return money to shareholders through dividends.
Free Cash Flow Example
Now that you know the FCF formulas, let’s give free cash flow calculation a hit with an example. Listed below is an income statement of a company ABC statement for the fiscal year. You’re supposed to calculate its FCF.
| Particulars | Amount |
| Cash Flow from Operating Activities | Rs 70,00,000 |
| Expenditure on machinery | Rs 15,00,000 |
| Expenditure on Furniture | Rs 20,00,000 |
Given,
Operating cash flow = Rs 70,00,000
Capital Expenditure = Expenditure on Machinery + Expenditure on Furniture
= 15,00,000 + 20,00,000
= 35,00,000
Here’s the required formula,
Free Cash Flow = Operating Cash Flow – Capital Expenditure
Free Cash Flow = Rs 70,00,000 – 35,00,000
Free Cash Flow = Rs 35,00,000
Therefore, ABC company has sufficient cash available to repay debts, pay dividends, and expand business.
Conclusion
Free cash flow is the prominent metric that helps investors to have a deeper understanding of a company’s financial health, cash generation capabilities, and ability to deal with economic fluctuations. Simply put, the higher the FCF a company has, the healthier and more growthful it is. To learn more about such financial concepts, subscribe to StockGro.
FAQs
Free cash flow is generally used to figure out whether a company has sufficient funds to manage its short-term obligations or whether it may have to approach external financial sources.
There are two main free cash flow morulas that are mentioned below:
(i) Free cash flow = sales revenue – (operating costs + taxes) – investments needed in operating capital
(ii) Free cash flow = Total operating profits with taxes – total investment in operating capital
Free cash flow is basically the free (available) amount for the companies that they can use for the repayment of debts, paying dividends, and purchase of new assets.
Discounted free cash flow is a method used to calculate the value of an investment based on future cash flows. DFC (Discounted Free Cash) indicates the idea that money will be more valuable in the future. It is known as the time value of money.
A company’s high free cash flow showcases its efficient control over its costs and operations. Simply put, it is a clear sign of a healthy and well-run business.
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