Free Cash Flow

Free Cash flow is the cash available to all the capital providers of a company

There are two types of free cash flows

• Free Cash Flow to the Firm (FCFF)
  • Cash flow available to pay out to all capital providers such as common stock holders, debt holders, and preferred stock holders.
  • Free Cash Flow to Equity (FCFE)
    • Cash flow that is available strictly to the company’s common stock holders (equity)

The FCFF and FCFE are not reported on a company’s financial statements, therefore, the analyst or investor must perform necessary calculations to arrive at these figures.

Financial Statement Items

First, we review some of the necessary financial statement items need to compute FCF

Net Income: the Earnings of the company after operating, interest, depreciation, and tax expenses have been made

Noncash charges: include items such as depreciation which do not represent an actual outflow of cash

Capital Expenditures: the company’s investments in fixed assets and capital. These are an important source of future growth for a company

Working Capital: the company’s short-term capital necessary to conduct its daily business operations. These include:

• Receivables
• Inventory
• Payables

Cash Flow from Operations: The net amount of cash from the company’s operating activities

Interest Expenses: the company’s costs of assuming debt

Liabilities / Borrowing: The amount that the company borrows in terms of its debt obligations

FCFF and FCFE Equations

Free Cash Flow to the Firm (FCFF)

Cash available after operating expenses, working capital, and capital expenditures have been taken into consideration.

The company can use this cash flow to:

• Pay its common equity holders with dividends
• Pay its debt holders back (i.e., pay down its principal)
• Pay its preferred equity holders

Equation:

FCFF = Net Income + Noncash items + Interest Expenses (1-Tax Rate) – Capital Expenditures – Working Capital Requirements

Free Cash Flow to Equity (FCFE)

Cash available to common equity holders after payments related to debt are made and working capital and capital expenditures are taken into account.

The payment s relating to debt include:

• Payments such as interest expenses and debt principal repayment

The company can use this available cash flow to pay its common stock holders.

Equation:

FCFE = Net Income + Noncash items – Capital Expenditures – Working Capital Requirements + Net Borrowing

Why are FCFs used?

Some uses and applications of FCFs

• To assess the company’s ability to pay its equity and debt capital providers
• FCFs can be used when the company does not pay dividends, and as such, does not have a track record of paying equity holders. FCFs can indicate how much the firm can pay out
• FCF can be used by a company to repay the principle related to its long-term debt
• FCFs are used with for firm valuation purposes, such as with Discounted Cash Flow (DCF) models to measure a company’s intrinsic value

Conclusion

Free cash flows are a company’s cash available after operating expenses, capital expenditures and working capital requirements have been accounted for. It represents the funds available for the company’s capital providers. The FCFF represents cash available to both equity and debt capital providers, while the FCFE is the cash flow that can be reserved to the company’s common equity holders. FCFs play an important role in financial modeling and discounted cash flow techniques in determining valuation for an asset or financial security

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