Types of free cash flow
To begin with, let us understand the two primary types of cash flows that are important in financial analysis:
1. Free cash flow to the firm (FCFF)
FCFF calculates the cash available to all stakeholders, both debt and equity holders, after covering all expenses, including capital expenditures and working capital. It is particularly important for assessing a company's ability to pay off debt and distribute dividends. FCFF can be calculated by using the cash flow produced from operations. Alternatively, the company’s net income can also be used for its computation. Here is the formula for calculating FCFF:
Free cash flow to the firm = Cash flow from operations - Capital expenditure
2. Free cash flow to equity (FCFE)
FCFE is the measure of cash available to equity shareholders, factoring in capital expenditures, working capital, and debt payments. FCFE is also called levered cash flow. This is essentially the amount of money the company can use for its dividend payouts to its shareholders. This sum can also be utilised towards stock buybacks after all debts, expenses, and reinvestments are accounted for. For investors looking at the financial market, it helps evaluate the company's potential to generate returns for shareholders. The formula for calculating FCFE is:
Free cash flow to equity = Free cash flow to the firm + Net borrowing - Interest × (1-Tax)
Importance of free cash flow
FCF plays a pivotal role in financial decision-making for both management and investors:
- For management:
Positive FCF enables companies to plan for future growth, such as pursuing new projects, expanding operations, or acquiring other businesses. It also ensures the organisation can meet its financial obligations, including debt payments. On the other hand, negative FCF may necessitate seeking external funding to sustain operations or finance new ventures.
- For investors:
Investors often prioritise companies with healthy FCF profiles, viewing them as indicators of strong financial prospects and growth potential. High FCF suggests the ability to service debt, reinvest in the business, and offer shareholder returns. Furthermore, FCF is often regarded as a more accurate measure of financial performance compared to net income, as it directly reflects a company’s ability to generate cash.
Investors may find undervalued shares in companies with high FCF appealing, presenting opportunities for sound investments. Additionally, FCF often serves as a critical input for stock valuation and debt management considerations.
By highlighting a company’s financial flexibility, FCF supports informed decision-making and inspires confidence among stakeholders.
How to calculate free cash flow?
The formula for calculating free cash flow is:
FCF = Operating cash flow - Capital expenditures
Operating cash flow refers to the cash generated from the company's day-to-day operations, and capital expenditures represent the funds spent on capital assets such as property, plants, and equipment.
Free Cash flow example
Let us consider a real-world example of a company operating in the Indian market, ABC electronics, to understand the calculation of free cash flow (FCF) more vividly. In this scenario, ABC electronics has faced some financial challenges, making the FCF calculation critical.
Income statement for ABC Electronics:
- Total revenue: Rs. 11,56,93,400
- Cost of revenue: Rs. 6,92,74,700
- Selling, general, and administrative expenses: Rs. 1,08,27,900
- Interest expense: Rs. 7,69,000
- Income tax: Rs. 44,46,800
- Income from operations: Rs. 1,41,66,300
- Net income: Rs. 1,40,26,300
Additional financial information:
- Depreciation and amortisation: Rs. 18,48,100
- Current assets: Rs. 3,67,49,700
- Current liabilities: Rs. 2,56,53,000
- Fixed assets: Rs. 1,75,59,900
Now, let's calculate the free cash flow for ABC electronics:
FCF = Operating income – Capital expenditure
Operating income (or income from operations) is Rs. 1,41,66,300, as mentioned in the income statement.
To calculate capital expenditure, we need to consider both the change in net working capital and the depreciation and amortisation:
- Change in net working capital (NWC):
NWC = Current assets - Current liabilities NWC = Rs. 3,67,49,700 - Rs. 2,56,53,000 NWC = Rs. 1,10,96,700
- Depreciation and amortisation: Rs. 18,48,100
- Fixed assets: Rs. 1,75,59,900
Now, we can calculate capital expenditure:
Capital Expenditure = Change in NWC + Depreciation and Amortisation + Fixed Assets Capital Expenditure = Rs. 1,10,96,700 + Rs. 18,48,100 + Rs. 1,75,59,900 capital expenditure = Rs. 3,05,04,700
Now, let us plug these values into the free cash flow formula:
FCF = Operating income - Capital expenditure FCF = Rs. 1,41,66,300 - Rs. 3,05,04,700
The result is:
FCF = -Rs. 1,63,38,400
Interpretation
In this particular year, ABC electronics has a negative free cash flow of -Rs. 1,63,38,400. This indicates that their capital expenditure exceeds their available cash flow. In other words, the company does not have enough cash to cover both its operating expenses and the required investments in capital assets.
Significance of free cash flow
Free Cash Flow serves as a reliable indicator of a company’s financial efficiency and liquidity. Changes in FCF often provide a clear picture of an organisation’s performance, with the nature of the change—whether positive or negative—shaping stakeholders’ views.
- Increase in FCF:
An increase in FCF generally signals strong financial health. Possible reasons for this include:
- Disposal of corporate assets.
- Reduced capital expenditure (CAPEX).
- Cost-cutting measures, such as delayed salary payments or reductions in marketing and maintenance expenses.
- Receipt of substantial deposits, such as from closing significant deals.
- Delays in accounts payable, which temporarily boost available cash.
- Growth in accounts receivable bulk.
- Decrease in FCF:
A decline in FCF might point to increased financial strain or investment-heavy operations. Common causes include:
- Higher working capital requirements.
- Large inventory purchases.
- Investments in new equipment or technology.
- Rapid expansion or development efforts.
Understanding the reasons behind fluctuations in FCF is essential for assessing its implications. Analysing the advantages and disadvantages of FCF provides deeper insights into its significance.
Advantages of free cash flow
Utilising free cash flow as a financial metric offers several advantages:
1. For financial analysts and investors
- Unlike net income or earnings per share, FCF provides a more precise representation of a company's financial health by considering real cash flow.
- Investors and analysts use FCF to evaluate a company's potential for generating cash, making it a key factor in investment decisions.
- Learn if a business is giving out dividend payments.
- Understand if there is a difference between a business’s actual paying capacity and the dividend payouts.
- Align a company’s profitability in the context of the available cash.
- FCF can be used to compare companies across various industries, as it focuses on cash generation rather than industry-specific accounting methods.
2. For creditors
- Companies need significant capital for their business operations. For this, seeking financing from creditors is a common source of funds. The higher the loan, the higher the risk involved (even for the creditors!). Thus, creditors rely on FCF to understand companies' repayment capacity.
- FCF also helps creditors decide if they should sanction a loan.
3. For a business partner
- Imagine you want to join a business on a partnership model. For this, you would be seeking a company which has sustainable earning potential. For this, FCF can be an important metric as it can help you understand the operational viability of businesses in making this important decision.
Disadvantages of free cash flow
Nevertheless, free cash flow comes with certain limitations:
1. Data requirements
Calculating FCF demands detailed information about a company's operations, which may not always be readily available.
2. Fluctuating variables
FCF can be influenced by changes in working capital or capital expenditures, making it sensitive to short-term fluctuations.
3. Time value of money
It does not consider the time value of money, which can affect the real value of cash flows over time.
Conclusion
Free cash flow provides a deeper understanding of a company's financial health, cash generation capabilities, and ability to weather economic fluctuations. While the financial market presents unique challenges, leveraging FCF offers a valuable tool for making sound investment decisions and understanding the financial stability of companies in this dynamic and diverse marketplace.
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