Key Takeaways
- Free cash flow (FCF) is the amount of cash left after considering all operational expenses and capital investments. FCF can be negative or positive.
- FCF provides insight into the financial health of the company. It is commonly used in financial analysis, valuation, and determining a company’s ability to generate cash.
- FCF can be calculated using different factors, such as revenue, operating cash flows, and depreciation value.
Introduction
To preserve the company’s financial health and avoid circumstances like cash shortages or deficits, businesses must be aware of the implications of cash inflow and outflow. Free cash flow (FCF) provides insight into the investment of money and the associated returns. It is one of the important financial metrics stakeholders keep track of to determine the sustainability and future potential of the businesses.
FCF is the cash that remains from a company’s operations after subtracting operating expenses and capital expenditures. Understanding FCF provides business owners with valuable insights into their cash generation capability, whether they have a surplus or deficit.
In this blog, we will understand the meaning of free cash flow along with some real-world examples and how to calculate it so you can leverage the cash properly and make strategic and informed business decisions.
What is Free Cash Flow (FCF)?
Free cash flow definition: (FCF) is the amount of cash left after accounting for cash outflow expenses, related to operating expenses and capital investment (CapEx). “Free” cash is generally utilized in reinvestments, debt repayments, acquisitions, and maintaining cash reserves that can be used in the long run.
For stakeholders, FCF gives a clear picture of the company’s cash generation over time and indicates if there is a cash surplus or deficit. If there is extra cash, they have the option to reinvest it, while if there is a shortfall, they can strategically cut cash outflows. FCF offers an understanding of financial performance and ROI, aiding in pinpointing areas for enhancement and making strategic decisions in line with long-term business objectives.
Benefits of Free Cash Flow
FCF provides organizations with a myriad of benefits related to financial stability. Here are some of the key benefits of FCF:
Financial performance
FCF provides insights into the company’s financial performance. It considers the actual cash generated from daily operations. It also helps stakeholders understand the ability of their business to generate cash flow and helps in determining profitability and long-term sustainability.
Flexibility and financial stability
A positive FCF represents a cash surplus. This cash can be reinvested into different projects and acquisitions and can be extremely useful during challenging times. This helps businesses gain financial stability and sustainability in the long run.
Investment and growth opportunities
FCF can be considered “internal funding” as the funds can be utilized internally to invest in growth opportunities, avoiding the external funding route. The funds can be used for R&D, expansion, acquisitions, and strategic initiatives.
Debt repayment and shareholder returns
FCF can be utilized to repay debt payments, which helps in reducing interest expenses. Additionally, companies can utilize FCF to reward dividends, share buybacks, or any other form of capital return.
Valuation and investor confidence
FCF is an important metric that financial advisors and investors look at during company valuation. Since FCF gives an idea about the company’s ability to generate cash, this contributes to increasing the confidence of investors.
Types of Free Cash Flow
In a broader sense, there are two types of FCF, namely:
Free cash flow to the firm (FCFF)
Free cash flow to the firm (FCFF) represents the cash generated by a company’s operations that is available to all of its stakeholders, including equity and debt holders, after accounting for operating expenses such as capital expenditures, taxes, and depreciation. FCFF provides insight into a company’s ability to generate cash and fund future investment opportunities, pay debts, and reduce interest rates. As a comprehensive measure of cash flow, FCFF is integral to determining the company’s value and its ability to create long-term shareholder wealth.
Free cash flow to equity (FCFE)
Free cash flow to equity (FCFE) represents the cash available to all the company’s equity holders after accounting for all the expenses, reinvestments, and debt obligations. FCFE provides insight into a company’s equity valuation, cash flow analysis, and potential to generate shareholder returns through dividends or share buybacks.
What is the Free Cash Flow (FCF) Formula?
To determine FCF, one of the most commonly used formulas is to deduct capital expenditures from operating cash flow. Positive free cash flow means the company’s operational cash generation surpasses its CapEx. Negative free cash flow suggests the company is spending more on CapEx and operating activities than it is generating from cash inflows.
FCF = Operating Cash Flow – Capital Expenditures
How to Calculate Free Cash Flow (FCF)?
As different companies have different financial statements, there are several different ways to calculate free cash flow. Here we break down the four ways to calculate the FCF:
Using operating cash flow
Calculating FCF using the operating cash flows (OCF) is one of the most convenient ways because the OCF can be easily found in the cash flow statements. Look for the section that reports cash flows from operating activities. While calculating OCF, adjust the non-cash expenses and working capital, if any.
If OCF comprises any non-cash expenses like depreciation and amortization, it is essential to include them while calculating OCF. If these non-cash expenses are not explicitly stated in the OCF, they can be located in the company’s income statement or financial statements’ notes. Additionally, it is important to account for any changes in working capital and make adjustments accordingly. Once, you have calculated the OCF, the non-cash expenses, and the working capital, you can calculate the FCF as follows:
FCF = OCF + Non-Cash Expenses – Changes in Working Capital
Using sales revenue
To calculate FCF using sales revenue, take the revenue generated by the company through its business and subtract the cost that is associated with generating that revenue (known as operating expenses; the sum of taxes, and all the operating costs) along with the net investment in operating capital.
FCF = Sales Revenue − (Operating Costs + Taxes) − Required Investments in Operating Capital
Using net operating profits
When calculating FCF using net operating profits, we always consider net operating profits after taxes (NOPATs). The first step is to calculate the NOPATs (multiplying the operating income by one minus the tax rate). Now, subtracting NOPATs and the net investment in operating capital gives us the FCF.
FCF = Net Operating Profit After Taxes − Required Investments in Operating Capital
Where,
Net Operating Profit After Taxes = Operating Income × (1 – Tax Rate)
Using amortization and depreciation
We must add the net income to the amortization and depreciation calculations to calculate FCF using this method. Because they are non-cash expenses and are not a real cash outflow, this is taken into consideration. We also need to take changes in working capital and capital expenditures into account.
FCF = Net income + (Depreciation/ Amortization) – Working Capital – CapEX
Examples of Free Cash Flow Calculation
Let’s take a look at some of the examples that calculate free cash flow using the different methods mentioned above:
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Calculating FCF using operating cash flow
Considering company ABC with:
Operating Cash Flow (OCF): $8,000,000
Non-Cash Expenses (e.g., depreciation, amortization): $2,500,000
Changes in Working Capital: $1,200,000 (positive change)
Now,
FCF = OCF + Non-Cash Expenses – Changes in Working Capital
FCF = $8,000,000 + $2,500,000 – $1,200,000
FCF = $9,300,000
In this example, company ABC has a free cash flow of $9,300,000 after considering the operating cash flow, non-cash expenses, and changes in working capital. A positive FCF indicates surplus cash available to the company after accounting for these factors.
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Calculating FCF using sales revenue
Considering company ABC with:
Sales Revenue: $10,000,000
Operating Costs: $6,000,000
Taxes: $1,000,000
Required Investments in Operating Capital: $2,000,000
FCF = Sales Revenue – (Operating Costs + Taxes) – Required Investments in Operating Capital
FCF = $10,000,000 – ($6,000,000 + $1,000,000) – $2,000,000
FCF = $1,000,000
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Calculating FCF using net operating profits
Considering company ABC with:
Operating Income: $5,000,000
Tax Rate: 25%
Required Investments in Operating Capital: $2,000,000
Now, FCF = Net Operating Profit After Taxes − Required Investments in Operating Capital
First,
Net Operating Profit After Taxes = Operating Income × (1 – Tax Rate)
NOPATs = $5,000,000 × (1 – 0.25)
NOPATs = $5,000,000 × 0.75
NOPATs = $3,750,000
Then,
FCF = $3,750,000 – $2,000,000
FCF = $1,750,000
Advantages and Disadvantages of Free Cash Flow
We talked about the benefits of free cash flow above, however, there are some limitations as well. Here, we discuss the advantages and disadvantages of free cash flow:
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Advantages |
Disadvantages |
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Free cash flow offers a clear picture of the company’s financial health by showing how much cash it generates after accounting for operating expenses and expenditures. |
Free cash flow might not always paint a clear picture of the company’s financial health. Especially, for capital-intensive industries with very high CapEX. This results in negative free cash flow, which might not always be accurate. |
|
Positive FCF enables businesses to pay off debt, reinvest in their operations, and even engage in M&A. |
Free cash flow is vulnerable to economic conditions. FCF can be influenced by macroeconomic factors such as tax regulations and interest rates. |
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FCF is an important valuation metric investors consider while estimating the value of the company and making investment decisions. |
The timing difference between the cash inflows and outflows can affect the results and FCF may not account for it. |
How Can HighRadius Help in Improving and Managing Free Cash Flow?
Most businesses are still dependent on Excel for cash flow analysis, with very limited features that lead to inaccurate results, a lack of cash visibility, and a lot of manual work. However, with HighRadius’s cash forecasting solution, businesses can easily adapt to Livecube, which is an Excel-like interface but better. We provide advanced cash forecasting capabilities that leverage machine learning and predictive analytics. By accurately forecasting cash inflows and outflows, companies can better manage liquidity, optimize working capital, identify cash deficits, and ensure sufficient cash reserves, ultimately improving free cash flow.
HighRadius’ cash forecasting solution helps identify opportunities to optimize working capital by streamlining and optimizing accounts receivable and accounts payable processes. By accelerating receivables collection and optimizing payment terms with suppliers, companies can improve cash conversion cycles, reduce working capital requirements, and enhance free cash flow.
FAQs
1) What does FCF stand for?
FCF stands for “Free Cash Flow.” It represents the cash generated by a company’s operations after accounting for capital expenditures. It is a crucial measure of financial health and the ability to pursue growth opportunities.
2) How to calculate cash flow to creditors?
To calculate the cash flow to creditors (CFC), the sum of ending long-term debt and beginning long-term debt should be subtracted from the total interest paid during the period. The formula to calculate cash flow to creditors is: CFC = Interest paid – (Ending long-term debt + Beginning long-term debt)
3) How to calculate free cash flow from financial statements?
Locate the capital expenditure and operating cash flow in the financial statements and deduct capital expenditure from operating cash flow, adjusting for changes in working capital. This provides information on cash generated after investments, offering insights into financial and growth potential.
4) How to calculate capital expenditures for free cash flow?
To calculate capital expenditures for free cash flow, subtract depreciation from net capital expenditures (the difference between total CapEx and earnings from selling fixed assets). Formulas: CapEx = Net CapEx – Depreciation & Net CapEx = Total expenditures – Proceeds from the sale of fixed assets.
5) What is a free cash flow valuation model?
The free cash flow valuation model assesses if an investment is genuinely worthwhile through financial analysis. The idea behind this method is that a company’s ability to generate cash flow, considering expenses and investments, decides the actual worth of the company.
6) Can a company have negative free cash flow?
Yes, a company can have negative free cash flow if its cash inflow is insufficient to cover its capital expenditures and other cash obligations. This situation may arise due to high capital investments, operating losses, or excessive debt obligations.
