What is a Free Cash Flow?
Free cash flow (FCF) measures a company’s financial performance. It shows the cash that a company can produce after deducting the purchase of assets such as property, equipment, and other major investments from it’s operating cash flow. In other words, FCF measures a company’s ability to produce what investors care most about: cash that’s available be distributed in a discretionary way.
Types of Free Cash Flow
When someone refers to FCF it is not always clear what they mean. There are several different metrics that people could be referring to.
The most common types include:
- Free Cash Flow to the Firm (FCFF) also referred to as “unlevered”
- Free Cash Flow to Equity also knows as “levered”
To learn more about the various types, see our ultimate cash flow guide.
What is the importance of the free cash flow?
Knowing the company’s free cash flow enables management to decide on future ventures that would improve the shareholder value. Additionally, having an abundant FCF indicates that a company is capable of paying their monthly dues. Companies can also use their FCF to expand business operations or pursue other short-term investments.
Compared to earnings per se, free cash flow is more transparent in showing the company’s potential to produce cash and profits.
Meanwhile, other entities looking to invest may likely consider companies that have a healthy free cash flow because of a promising future. Couple this with a low-valued share price, investors can generally make good investments with companies that have high FCF. Other investors greatly consider FCF compared to other measures because it also serves as an important basis for stock pricing.
How is FCF calculated?
There are various ways to compute for FCF, although they should all give the same results. The formula below is a simple and the most commonly used formula for levered free cash flow:
Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures
Most information needed to compute a company’s FCF is on the cash flow statement. As an example, let Company A have $22 million dollars of cash from its business operations and $6.5 million dollars used for capital expenditures, net of changes in working capital. Company A’s FCF is then computed as:
FCF = $22 – $6.5 = $15.5m
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What are some limitations associated with the free cash flow?
The company’s net income greatly affects a company’s free cash flow because it also influences a company’s ability to generate cash from operations. As such, other activities (i.e. those not within the core business operations of a company) from which the company generates income must be scrutinized deeply in order to reflect a more appropriate FCF value.
On the investors’ side, they must be wary of a company’s policies that affect their declaration of FCF. For example, some companies lengthen the time to settle their debts to maintain cash or, the opposite; shortening the time they collect debts due to them. Companies also have different guidelines on which assets they declare as capital expenditures, thus affecting the computation of FCF.
Applications in financial modeling
For professionals working in investment banking, equity research, corporate development, financial planning & analysis (FP&A) or other areas of corporate finance, it’s very important to have a solid understanding of how FCF is used in financial modeling.
Discounted Cash Flow, or DCF models, are based on the premise that investors are entitled to the free cash flow of a firm, and therefore the model is based solely on the timing and the amount of those cash flows.
To learn more about DCF modeling, check out CFI’s online financial modeling courses.
Screenshot from CFI.