Free Cash Flow (FCF)

Free Cash Flow (FCF) is a methodology of calculating the amount of cash available for a company to pay its securities holders such as equity holders, preferred stockholders, debt holders, and convertible securities holders. Free cash flow is important to such securities holders. With this, they can determine the amount of money that can be deducted from a company’s income without hurting the company operations.

In other words, free cash flow can be defined as the money made by a company through its operations minus expenditures on assets. It is the cash left for a company after paying for its production costs, and capital expenditures. Free cash flow is usually different from net income. This is because free cash flow takes into account the cost of capital goods acquired. It changes it into working capital.

Free cash flow is an important measurement that shows how efficient a company is at generating cash. It measures the ease with which a company can grow and pay more dividends to its securities holders. Some investors prefer using free cash flow to net income because they believe that free cash flow is more difficult to manipulate than net income.

Free Cash Flow Formula

FCF = \text{Operating Cash Flow} - \text{Capital Expenditures}

Free cash flow can be calculated in various ways depending on the data available. One common way is to subtract the tax from the earnings before interest and tax, add depreciation and amortization, and then subtract changes in working capital and capital expenditure. However, the formula needs refinements and adjustments to smoothen out distortions.

The second one, shown above, is simplified to the difference between the cash flow from operations and capital expenditures needed to continue the operations.

The operating cash flow can be located in the cash flow statement and is sometimes referred to as cash flow from operations or net cash from operating activities. It should be noted that the operating cash is the cash flow from operating activities only.

If there is cash flow from the sale of equipment or some landed property, the resulting cash flow cannot be added to the operating cash for the company because the cash income is a one time or non-periodic event that may not happen again, except if the company is a real estate company that sells properties. So operating cash only comes from the regular activities of the company.

Capital expenditures also do not include additional investment in new equipment. However, it includes the cost of maintenance on the equipment.

Free Cash Flow Example

The company Tinex has filed its 10K statements, and according to the statement, its cash flow from operations for the 2019 fiscal year is $2.8 billion. Tinex also made an additional income of $11 million from the auctioning of old equipment. The capital expenditure for the same fiscal year, 2019, is $730 million. What is the free cash flow for Tinex?

Now let’s break it down and identify the values of different variables in the problem.

  • Operating cash flow = $2.8 billion
  • Capital expenditures = $730 million

Now, we can apply them to our formula:

FCF = 2.8b - 0.73b = \$2.07b

Tinex has free cash flow of $2.07 billion.

This means that Tinex has $2.07 billion to spend on dividend payments and the expansion of operations. It should be noted how the calculations did not include the cash made from the auctioning of old equipment since that is not part of the daily operations of Tinex.

It can be seen from the formula also that the free cash flow can be increased by upping the cash flow from operations or by reducing the capital expenses. Most times, when the free cash flow of a company increases, the company has increased its cash flow from operations by expanding operation activities or making their production processes more efficient.

Free Cash Flow Analysis

Free cash flow is the amount of money that is available for a company to pay dividends to its shareholders, expand operations and deleverage its balance sheet. For most companies, an increase in free cash flow is an indication of increased earning.

Investors are very interested in free cash flow because a company with high free cash flow will have enough cash to pay shareholders. Growth in free cash flow also shows that there is an improvement in company operating procedures, higher efficiency, share buybacks, cost reductions and debt elimination.

When a company’s share price drops and its free cash flow increases, it means that very soon, earnings per share will increase.

On the other hand, if the free cash flow of a company is continuously decreasing, it is a sign that the company will be unable to sustain earnings growth. This might show also that the company is becoming less efficient, or production cost has gone high. Decreasing free cash flow may force companies to boost their debt profile to remain in business.

Remember that a decreased free cash flow may mean that the company is making heavy capital investments. That may mean increased earnings in the future. A very high free cash flow may also mean that the company is not updating its capital assets. As a result, they may face a crisis later on.

The major drawback of using free cash flow is that capital expenditures are not static. They may vary drastically from time to time or from one company to another. It is, therefore, better to compare free cash flows between different periods for the same company when gauging performance.

Free Cash Flow Conclusion

  • Free cash flow is the amount of money that is available for a company to spend on payment of dividends to stakeholders, and deleveraging of balance sheets.
  • It is obtained by subtracting the capital expenditures from the cash flow from operations.
  • The cash flow from operations does not include cash from one-time investment events like selling of a property or equipment.
  • Increasing free cash flow indicates to investors that a company is increasing efficiency and boosting its market share.

Free Cash Flow Calculator

You can use the free cash flow calculator below to quickly calculate the free cash flow of a company by entering the required numbers.