Free Cash Flow

free cash flowFree cash flow represents the cash a company can generate after required investment to maintain or expand its asset base.

It is a measurement of a company’s financial performance and health. There are two other types of free cash flow: free cash flow for the firm and free cash flow to equity.

Free cash flow is the cash flow available to all investors in a company, including common stockholders. FCF provides a useful valuation technique investors often use to derive a firm’s value or the value of a firm’s common equity. Often, investors will calculate a firm’s value using FCF valuation model techniques and subtract net debt to arrive at a company’s equity value in a simple capital structure.

Free Cash Flow – FCF in Company Analysis

FCF measures the level of cash available to a company’s investors net of all required investments in working capital and fixed capital, including plant, property and equipment, otherwise known as capital expenditures, plus any expenses required to remain a going concern. FCF is an important measure because it allows a company to pursue opportunities that enhance shareholder value. Excess cash can expand production, develop new products, make acquisitions, pay dividends and reduce debt.

As FCF increases, balance sheet strength and health rises; however, it is important to note that negative FCF is not a bad indicator. If FCF is negative, it could be a sign a company is making significant investments. If these investments earn high returns, the strategy has the potential to add value in the long run.

Free Cash Flow – FCF Calculations

One can calculate FCF multiple ways. Most commonly, the FCF calculation begins with Cash Flow From Operating Activities, but it can also start from revenue or Net Operating Profit After Taxes.

One can calculate FCF using the following equations:

FCF = Cash Flow From Operating Activities – Capital Expenditures

FCF = Net Operating Profit After Taxes – Net Investment in Operating Capital

FCF = Revenue – Operating Costs and Taxes – Required Investments in Operating Capital

Where:

Net Operating Profit After Taxes = Revenue – Operating Costs and Taxes

Required Investments in Operating Capital = Net Investment in Operating Capital

If calculated properly with all the same inputs, all three equations should produce the same result for FCF.

 


 

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