Free Cash Flow (FCF) consists of all the earnings produced by a business that are available to invest in new ventures or reduce its debt. It is essentially derived from the company’s net earnings plus depreciation and amortization charges for the time period (as these are not cash expenditures) minus capital expenditures, which are investments in fixed assets, often required to maintain regular operations.
What is Free Cash Flow?
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The Free Cash Flow measure is extensively employed for business valuation, capital budgeting, investments and project development. It can also be understood as a business actual “earning power” as it adds back depreciation and amortization charges to net earnings, given that these charges do not affect the cash position.
The most popular valuation tools such as the Discounted Cash Flow model employ Free Cash Flow as the main input to calculate the value of a business. Also, the multiples approach also employs free cash flow per share multiplied by a valuation multiple derived from analyzing the market value of similar companies.
A business free cash flow can be turn into a ratio of sales or enterprise value to also establish comparisons with peers to determine how healthy the company is in terms of the cash flow it generates. A large amount of free cash flow is essential for a business to continue growing without having to step into debt.
Free Cash Flow Formula
The Free Cash Flow (FCF) formula for any time period is calculated by following:
FCF = Net Earnings + Non-Cash Expenses – Net Change in Working Capital – CapEx
Free Cash Flow Equation Components
FCF: Free Cash Flow
Net Earnings: The net gain resulting after deducting all costs, expenses and taxes from the business’ revenues.
Non-Cash Expenses: Including depreciation, amortization and any other non-cash disbursements listed in the income statement.
Change in Working Capital: It refers to net change in current assets plus the net change in current liabilities.
CapEx: Total Capital Expenditures for the time period, which includes all investment made in fixed assets.
FCF Example
Jones Publishing is a book publishing firm that has been in business for 4 years. They have seen their business grow dramatically in the last 2 years since they signed an unknown author whose books became very popular, in the subject of science fiction.
Recently, the firm’s partners have been thinking about expanding their offices to other countries where they see potential. They hired a financial analyst to check the current situation of the business to see if that was a reasonable step considering the financial situation of the firm.
Last year, the firm made $2,300,000 in net earnings, with a depreciation of $46,500 and amortization charges from the payment of certain copyrights that added up to $245,000. Capital expenditures where not significant, as the firm only invested in remodeling their existing office to accommodate new staff. At the end of that year, capital expenditures were $122,000. Finally, current assets grew in $54,600 due to an increase in inventory levels and current liabilities increased by $12,000. As a result, the Net Change in Working Capital was $42,600 ($54,600 – $12,000).
As a result, the company’s Free Cash Flow last year was:
FCF = $2,300,000 + $291,500 – $42,600 – $54,600 = $2,494,300
The company’s expansion plans involve opening new offices in 3 different countries, with an estimated cost of $890,000 for the entire project. According to these analysis, the company is more than able to undertake this venture, as they generate enough cash flow last year to do so. The analyst also recommended that a dividend should be distributed, as the company has no other plan and there are some funds that will remain unused.
Free Cash Flow Ratio Analysis
The best way to analyze the Free Cash Flow metric is to break it down in pieces to understand why the end result is what it is. On the other hand, the amount by itself doesn’t say much, unless its compared to other key metrics such as sales or assets, in the form of a metric.
There are three ratios that can be employed to assess if the business capacity to generate Free Cash Flow is high:
- FCF / Net Sales: This ratio tracks how much of each sale is converted into Free Cash Flow. A company with the capacity to generate a substantial percentage of FCF from its sales its highly valuable.
- FCF / Total Assets: It measures the capacity of a business’ assets to generate Free Cash Flow. A manufacturing or capital intensive business will track this ratio very close.
- FCF / Total Equity: A ratio that unveils the business capacity to generate solid returns on the investment made by its shareholders.
Comparing the result of any of these three ratio with peer companies would be beneficial to understand how the business is performing.
In the example above, not enough information was given to determine if the Free Cash Flow generated by the publishing business was actually large compared to the company’s sales, assets or equity, but, it can be inferred that it is given the fact that publishing businesses are not capital-intensive and most of their assets are rights to publish the books they acquire.
Free Cash Flow (FCF) Uses, Cautions, Pitfalls
The ratios mentioned above can sometimes be misleading if the variables that lead to the apparently satisfactory results are not carefully dissected.
First of all, the Free Cash Flow measure can be broken down to determine where the actual figure comes from. By separating each of the elements involved, one can conclude that a high result may come from:
- Large net earnings.
- Favorable changes in working capital (say, a substantial decrease in current assets or a substantial increase in current liabilities).
- Low capital expenditures.
- Large non-cash expenses.
Identifying the source of a large Free Cash Flow metric is key to determine its sustainability. If a Free Cash Flow figure looks big, and after analyzing the source it turns out that the company reduce its capital expenditures dramatically, the Free Cash Flow available may not necessarily be positive if there’s no plan to invest the money right away.
In turn, if a favorable change in working capital is the major source of the Free Cash Flow, either because the inventory levels were decreased or the size of the accounts receivables were reduced, the analyst must ask the reason for this and what would be the destination of the money generated, as in both cases, those are situations that fall outside the ordinary.