Fri. Aug 12th, 2022
    Free cash flow

    Free Cash Flow

    Free Cash Flow is the ability of a company to generate additional resources. It corresponds to the cash portion of the self-financing capacity obtained during the year and which is not allocated to the purchase of new assets. In short, it measures of the net cash flows within a company (cash inflows and outflows).

    Who uses it?

    Free Cash Flow (FCF) is one of the indicators most followed by business leaders, banks, investors and other analysts. If it is so important, it is because it makes it possible to measure the financial performance of a company.

    Concrete example of the application of Free Cash Flow

    To concretely explain the principle of Free Cash Flow (FCF), let’s take the example of a plumbing company.

    The company’s cash flow will be fed by its current income: the services and products sold (interventions, equipment, advice, etc.).

    At the end of the month, the person at the head of the company will use this cash to:
    • pay its employees;
    • buy back the equipment sold or used;
    • renew damaged tools;
    • maintain its premises and the company vehicle (painting, repairs, etc.);
    • and of course pay the owner him/herself.

    Once these expenses have been paid, if there is money left over from the income received over the past month, it will constitute what is called Free Cash Flow.

    This capital can be used in different ways by our plumbing company:
    • Invest in the growth of the company, by buying out a competitor or new premises, for example;
    • Reimburse part of the company’s debts, which will allow it to be less dependent on banks and other creditors, and to belong more concretely to its shareholders (here, the person at the head of the company);
    • Pay part or all of this capital to shareholders in the form of dividends.

    What is Free Cash Flow (FCF) used for?

    Calculating the FCF of your company allows you to have a concrete idea of ​​its financial performance, but also of its potential actions. Seizing an investment opportunity can turn into a fiasco if you do not have an exact and concrete idea of ​​the state of your cash flow.

    It is for this reason that FCF is an indicator so often followed by a company’s decision makers, creditors, investors and analysts. Without cash, the latter will find it difficult to develop new offers, acquire new assets, pay dividends or reduce its level of indebtedness.

    FCF, or available cash flow, is a very precise tool for measuring the good financial health of a company. Well interpreted, it makes it possible to draw relevant conclusions on the existing situation, and to make decisions for the future accordingly.

    Free Cash Flow and balance sheet: what are the differences?

    FCF or available cash flow, therefore makes it possible to know concretely whether a company generates a positive financial flow: in short, whether it generates value. It could be pointed out that there are already many tools to achieve this result, foremost among which are balance sheets. It would then be enough to look, at the end of a financial year, if the net result of the company is profitable, to arrive at the same conclusions as with the FCF.

    A more precise indicator than the simple balance sheet

    Mixed in this way, the entries in the balance sheets do not really reflect the money available to the company. The result of a financial year, for example, is calculated according to a multitude of accounting standards. The latter will sometimes have difficulty in translating the money actually generated during a certain period.

    Indeed, when a company invests, in the purchase of a building for example, this expense is smoothed over the entire investment period. A purchase worth USD 100,000, with an estimated amortization period of 10 years, will imply that the accounting result will only be reduced by €USD 10,000 each year for 10 years.

    Conversely, when a company makes a sale, the full amount is recorded in the accounting results, even if payment is not yet effective, or payment facilities are granted by suppliers.

    So many standards and deadlines that can complicate the calculation of the income actually generated if you go through a traditional balance sheet. This is where Free Cash Flow comes in, with its ability to perform this kind of calculation more concretely.

    Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE)

    A distinction must be made between two concepts that derive from Free Cash Flow: Free Cash Flow to Firm, which corresponds to the amount available to all investors, including debt holders, and FCF to Equity, which concerns FCF only available to shareholders.

    Free Cash Flow to Firm (FCFF)

    The FCFF is the amount of money available to investors, which includes debt holders. The amount of interest available is the after-tax amount. In practice, the interest expense must be added to the FCF.

    The FCFF is used in particular to assess companies. Indeed, it provides a good estimate of the cash flows available before any leverage effect generated by the company’s financing structure.

    There are several ways to calculate it:

    Method 1: Cash flow from operations + Interest x (1-tx tax) – Capital investments
    Method 2: Net profit + Depreciation + Other non-monetary interest + Interest x (1-tx tax) – Capital investments – Investments in working capital.

    Free Cash Flow to Equity (FCFE)

    The FCFE remunerates, for its part, only the contributors of own funds (Equity): in other words, the shareholders. Its particularity also comes from the fact that it is net of tax and calculated after deduction of debt service and coverage of investment needs and variations in working capital requirement (WCR).

    How to Calculate CFC?

    A common method for calculating FCF is shown below:

    ElementSource
    Earnings before interest and taxes (EBIT)Current Income Statement
    + Depreciation & AmortizationCurrent Income Statement
    – TaxesCurrent Income Statement
    – Changes in Working CapitalPrior & Current Balance Sheets: Current Assets and Liability accounts
    – Capital expenditure (CAPEX)Prior & Current Balance Sheets: Property, Plant and Equipment accounts
    Free Cash Flow

    Note that the first three lines above are calculated on the standard Statement of Cash Flows.

    When net profit and tax rate applicable are given, you can also calculate it by taking:

    ElementSource
    Net ProfitCurrent Income Statement
    + Interest expenseCurrent Income Statement
    – Net Capital Expenditure (CAPEX)Current Income Statement
    – Net changes in Working CapitalPrior & Current Balance Sheets: Current Assets and Liability accounts
    – Tax shield on Interest ExpenseCurrent Income Statement
    Free Cash Flow

    where

    • Net Capital Expenditure (CAPEX) = Capex – Depreciation & Amortization
    • Tax Shield = Net Interest Expense X Marginal Tax Rate

    When Profit After Tax and Debt/Equity ratio are available:

    ElementSource
    Profit after Tax (PAT)Income Statement
    – Changes in Capital expenditure X (1-d)Balance Sheets, Cash Flow Statements
    + Depreciation & Amortization X (1-d)Prior & Current Balance Sheets
    – 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.

    ElementSource
    Net IncomeIncome Statement
    + Depreciation & AmortizationIncome Statement
    – Changes in Working CapitalPrior & Current Balance Sheets
    Cash Flows from Operationssame as Statement of Cash Flows: section 1, from Operations

    Therefore,

    ElementData Source
    Cash Flows from OperationsStatement of Cash Flows: section 1, from Operations
    – Investment in Operating CapitalStatement of Cash Flows: section 2, from Investment
    Levered Free Cash Flow

    How to analyze Free Cash Flow (FCF)?

    Analyzing the Free Cash Flow is essential, because it makes it possible to follow the evolution of the company’s financing needs. Within a group, for example, the financial director can consolidate the FCF forecasts of all the entities to find out whether, the following year, the group will generate or consume cash.

    The FCF of a company, over a given period, can be positive or negative. If the FCF, or available cash flow, is negative, the company will in theory see its debt increase. If it is positive, the company will be able to reduce it.

    Positive Free Cash Flow

    If the FCF generated by the company is positive, it is evidence of the company’s ability to generate excess cash once it has made its investment and operating expenses.

    Over several fiscal years, the year when the cumulative FCF becomes positive corresponds to the return on investment period. This is why a positive FCF, which does not increase its debt and approaches the point of return on investment, will be particularly reassuring for an investor.

    Negative Free Cash Flow

    Even though the term “negative” has connotations, a negative FCF is not necessarily a bad thing. Given that the FCF is calculated in particular by taking into account the investments made by the company, a negative FCF may only be linked to significant investments. These investments, which result in a negative FCF over one year, may be interrupted the following year, or even cause a substantial return on investment (ROI): all factors that can turn the Free Cash Flow into a positive one again.

    It is for this reason that it is essential to monitor and analyze Free Cash Flow over relatively long periods: it is only over substantial periods of time that one can assess the company’s real ability to generate money.

    Evolution of Free Cash Flow (FCF)

    Cumulative Free Cash Flow, the most important indicator?

    As we have seen, FCF is data that changes over time, and that is why it is relevant. At the start of the activity, a FCF may be negative due to investments, the constitution of the Working Capital Requirement (WCR), or even possible losses at start-up.

    Given that the moment when the cumulative FCF becomes positive corresponds to the start of the return on investment, it is essential to anticipate and control this aspect as much as possible. If the time before return on investment is long, an investor whose assets have a short lifespan will judge his investment as bad.

    How to preserve your Free Cash Flow?

    A business can look for ways to preserve its FCF. If economic performance is disappointing, in particular, the main lever for action will be expenditure management.

    Indeed, reducing or delaying spending can be wise in a difficult year. The financial division of the company must then discuss with the operational division, to find the right balance: can the investments, recruitments, and other expenses initially planned be called into question without operational performance suffering?

    A key indicator of a company’s performance, FCF must be carefully monitored and analyzed. Over time, it is one of the first indicators of a return on investment, and its correct interpretation allows investors, decision-makers and analysts to make coherent projections for the future of the company, and to make decisions accordingly.

    Quiz (Questions and Answers)

    1. Free cash flow to equity. If a firm has the following figures for 20X2:

    ●    Operating cash flow = 300
    ●    Interest paid = 40
    ●    Tax rate = 20%
    ●    Net investments in fixed capital = 200

    We consider two scenarios:

    ●    Scenario #1: Net borrowing in 20X2 is 30.
    ●    Scenario #2: Net debt repayment in 20X2 is 30.

    A.    What is the free cash flow to equity in Scenario #1 above?
    B.    What is the free cash flow to equity in Scenario #2 above?

    Part A: Free cash flow to equity (FCFE) = operating cash flow – fixed capital investments + net borrowing =

    operating cash flow
    –    fixed capital investments
    +    net borrowing

    = 300 – 200 + 30 = 130

    Part B: The free cash flow to equity = operating cash flow – fixed capital investments – debt repayment =

    operating cash flow
    –    fixed capital investments
    –    debt repayment

    = 300 – 200 – 30 = 70

    2. If the noncash revenues are $500,000 and the net income is $950,000 then the net cash flow would be…

    A) 475 000
    B) 485 000
    C) 1 450 000 000
    D) 450 000
    E) 500 000

    Answer D

    3. The type of bond which pays interest payment only when it earns is classified as…

    A) income bond
    B) interest bond
    C) payment bond
    D) earnings bond
    E) debt bond

    Answer A

    4. If the cash and equivalents, inventories and accounts receivables are classified as…

    A) assets on balance sheet
    B) liabilities on balance sheet
    C) payments on income statement
    D) earnings on income statement
    E) earnings on balance sheet

    Answer A

    5: The net investment in operating capital is $7000 and the net operating profit after taxes is $11,000 then the free cash flow will be

    A) −$18 000
    B) 18 000
    C) −$4 000
    D) 4 000
    E) 5 000

    Answer D

    6. The financial security issues by major banks and risk depends on strength of issuer is classified as…

    A) negotiable certificate of deposit
    B) mutual funds
    C) U.S treasury bills
    D) commercial paper
    E) funds