This article seeks to demystify the concept of free cash flow (FCF), its crucial role in assessing a company’s financial health, and its impact on generating shareholder value. The primary purpose is to make it evident to the readers how free cash flow carry’s more meaning than net profit (PAT).
Financial analysis plays a crucial role in assessing a company’s performance and its potential for generating shareholder value. One metric that holds great significance in this analysis is free cash flow. Free cash flow provides valuable insights into a company’s financial health and its ability to generate sustainable cash flows.
This article aims to demystify the concept of free cash flow and highlight its importance in evaluating companies. Let’s see how:
#1. What is Free Cash Flow? Definition and Purpose
Free cash flow (FCF) can be defined as the cash generated by a company’s operations after accounting for its capital expenditures (Capex). FCF represents the amount of cash available for distribution to investors, reinvestment in the business, or debt reduction (principal payment).
Free cash flow is really free cash available to the owners of the company. It is free because it has no immediate obligations.
Unlike net profit (PAT), free cash flow offers a more comprehensive but accurate measure of net profit. This net profit (FCF), which remains in the hands of the owners, is after accounting for all types of necessary and strategic expenses.
Before we see the formula and calculation part of FCF, I think, we should first know the types of FCF. Why? The ultimate objective of FCF analysis is to give oneself the ability to estimate the intrinsic value of a company. The steps to calculate the intrinsic value changes with the type of FCF we are considering.
Hence, let’s first know the types of FCF and then we’ll see the FCF formula.
(b) Types of Free Cash Flow
Broadly speaking, there are two types of people who have stakes in a company, borrowers and equity holders. The borrowers lend money (debt) for a fixed return called interest. Equity holders lend money for a stake in the company’s profits.
Free Cash Flow is free cash available for distribution to both borrowers and equity holders.
There are two variations of FCF:
- FCFF (Free Cash Flow To Firm): FCFF represents the cash flow available to all stakeholders of a company, including both equity shareholders and debt holders. It reflects the cash generated by the company’s operations that can be used for various purposes such as debt payments, reinvestment, or distribution to investors.
- FCFE (Free Cash Flow To Equity): FCFE focuses specifically on the cash flow available to equity shareholders. It represents the portion of cash flow remaining after deducting interest payments, taxes, and other obligations owed to debt holders. FCFE is important for equity investors as it indicates the cash that can be distributed to shareholders in the form of dividends or reinvested in the company.
The mathematical difference between FCFF and FCFE can be seen in the below-represented formula:
A Comparison Table
|Term||Free Cash Flow To Firm||Free Cash Flow To Equity|
|Description||It is free cash available for both borrowers and equity holders||It is free cash available for equity holders (shareholders) only|
|Debt Consideration||FCFF does not consider the effect of debt on the free cash available to the company.||FCFE considers the effect of debt. It adds net debt and subtracts interest|
|Discount rate consideration while using DCF Model||Weighted Average Cost of Capital (WACC = Cost of Debt + Cost of Equity)||Only Cost of Equity (or return expectations of the shareholders)|
|Preference For…||Both Debt Holders and Equity Holders (Shareholders)||Equity Holders (Shareholders)|
Now that we’ve understood that there are two types of FCF, let’s understand its application. First, we’ll look at the FCF formula.
(b) Calculation of Free Cash Flow
There are two ways to calculate the free cash flow of a company. First, by using the numbers in the cash flow report. Second, from the balance sheet and profit and loss account.
Analysts prefer the use of the Cash Flow Report because it deals only in cash. Why? Because money taken from the cash flow report removes the account receivables as it is a non-cash item. Similarly, all non-cash expenses which are still not paid, or have been paid in advance, are removed. As one is calculating the quantum of free cash flow, the use of the ‘net cash flow from operations’, which is the net of all non-cash items, looks more apt.
FCF from Cash Flow Report
Look into the cash flow report and all the numbers required to calculate FCF are neatly available. Hence, the best way is to download the cash flow statement from the company’s website, and then do the FCF calculation.
The first required number that we need for FCF calculation is net cash flow from operating activity. We’ll get this value ready-made from the cash flow report. In case you want to know how net cash flow from operating activities is arrived at, check the below infographics. You can also read this article for more details.
The next step is to calculate the FCFF and FCFE using the below formulas:
The value of Capex and the actual interest paid are clearly visible in the cash flow statement. Suggested Reading: How to read cash flow report.
In case, the available cash flow report is not as detailed, the balance sheet and P&L reports can be used to calculate FCF.
From Balance Sheet and P&L A/c
The below schematic representation highlights how to arrive at free cash flow (FCFF & FCFE) starting from the Net Profit (PAT) of the company.
In terms of formula, FCFF and FCFE is represented as shown below:
FCFF = Net Income + Interest Expense x (1 – Tax Rate) + Depreciation & Amortization – Capital Expenditures – Changes in Working Capital
FCFE = FCFF – Interest Expense x (1 – Tax Rate) + Net Borrowing
FCFF includes the impact of both equity and debt financing, while FCFE focuses on the cash flow available to equity shareholders after considering the impact of debt. Both metrics provide insights into a company’s cash flow generation and can help investors assess the financial health and value of a company from different perspectives.
Components of FCF (Explained)
Allow me to explain each of the ingredients of the Free Cash Flow formula.
Net Profit (PAT)
PAT is the estimated income after adjusting all expenses. This expense includes mandatory depreciation and amortization, interest, and income tax.
There is a general perception that net profit is the profit of the owners. But in reality, it is not. To keep running a business profitable and growing, there are a few additional strategic expenses that must be accounted for.
Adjustment of all these strategic expenses, and non-cash transactions, gives the actual profit of the owners (FCFE), called free cash flow. Warren Buffett refers to FCFE as the Owner’s Income.
[The strategic expenses could be prepayment of debt, funding Capex, funding of the increase in working capital, etc.]
Depreciation & Amortisation (D&A)
This is a non-cash expense reported in the company’s income statement. It is the adjustment of Capital Expenditures (CAPEX) already made by the company in the past.
The depreciation visible in the financial report is just a number. The actual cash flow has already happened in the past. All of this cash outflow of the past was not accounted for in the same year of its occurrence. As per GAAP, the CAPEX can be adjusted, as depreciation cost, throughout the life of the new asset.
For example, an asset worth Rs.100 crore was purchased by the company. The payment of it (Rs.100 Cr) was made in the Year 2021. The life of the purchased asset is say 8 years. So the company can book the total CAPEX in all of the next 8 years. Hence, in Yr-2022 it will book depreciation of Rs.12.5 crore. The same will be repeated for the next 7 years. At the end of the eighth year, the full cost of the asset would have been adjusted (12.5. x 8 = 100).
As depreciation is a non-cash expense, hence in the estimation of free cash flow, we can add this expense back to PAT. It then represents the actual cash available in the hands of the company.
In FCFF, we are calculating the free cash flow available to all types of investors of the company, the borrowers, and the shareholder (equity holders). Hence, the effect of debt is not taken into consideration here.
How does debt affect the company? In four ways:
- Increase in cash flow,
- Increase in interest expense,
- Tax savings due to interest paid,
- Increase in liability to pay back the principal.
In the calculation of FCFF, the four effects of debt are not considered. Why? Because FCFF is the quantum of free cash available with the company before the debt is served.
Suppose a company makes Rs.100 crore as FCFF. This is the money available to serve the interest of both shareholders and lenders. Now, suppose the company pays the following debt-related payments (a) Rs.10 crore of interest (b) Rs.8 crore as principal. After payment of this liability, the amount of FCF left with the company is Rs.82 crore (100-10-8), it is the FCFE.
Increase in Working Capital
Let’s first know about the components of working capital.
- Current Asset (CA): Total liquid assets which can be converted into cash in the next year. Example of such assets is account receivables, raw material, work in progress, finished good inventory, pre-paid liability (advance), savings deposits, etc.
- Current Liability (CL): Total liability that must be paid in the next year. Example of such liability is account payables, interest dues, income tax dues, short-term debts, etc.
Working Capital (WC) = CA – CL
Significance of Working Capital:
Suppose, a hypothetical company ABC reported Rs.100 Cr in the current asset (CA) in FY2022. The company also reported an immediate obligation of Rs.75 Cr as its current liability (CL). It means, out of the available Rs.100 Cr, Rs.75 Cr is already booked to handle current liabilities for the past year 2022. Hence, what is available for the year 2020 is only Rs.25 Cr.
WC (Rs.25 Cr) = CA (Rs.100 Cr) – CL (Rs.75 Cr)
This Rs.25 Cr is what we call working capital. This is the net available fund generated by the company’s operations in the year 2022, that can be used to fund the operational needs in the year 2023.
Suppose there is another hypothetical company XYZ which reported Rs.120 Cr. in the current asset (CA) in FY2022, and Rs.130 Cr in current liability (CL). As CL is more than CA, hence its working capital will be negative.
WC (-Rs.10 Cr) = CA (Rs.120 Cr) – CL (Rs.130 Cr)
Negative working capital means, in 2022 the company has not generated enough cash to fund its current liabilities. As a result, for 2023 the company starts with zero WC.
Moreover, in 12023 it must also ensure enough current assets to take care of the current liability deficit for 2022 and to meet the forthcoming current liabilities requirement for 2023.
Effects of Change in WC
How does change in WC (year on year), affect the company’s Free Cash Flow?
- An increase in WC is Positive: it is an indication that the company wants to keep more liquid assets for its forthcoming operation needs. Hence, this amount is deducted from the reported PAT.
- An increase in WC is negative: it is an indication that the company wants to keep fewer liquid assets for its forthcoming operation needs. Hence, this amount gets added to the reported PAT.
5. Capital Expenditure (CAPEX)
Capex is the money that a company has spent to expand & upgrade its asset base. In this process, they either buy new assets (expansion) or enhance the capability of their existing assets (modernization).
CAPEX is also an expense for the company. But the way Capex is reported in financial statements is different from other expenses. Normally, all expenses are reported in the company’s P&L A/c as it is booked. But CAPEX cost is booked in a staggered way, as depreciation, throughout the life of the asset.
If one does not have access to the company’s cash flow report, CAPEX can also be calculated from the numbers published in the balance sheet. We can use the below formula to calculate CAPEX:
6. Debt & Its Effect
Debt plays a significant role in the calculation of both FCFE and FCFF. Here’s how it affects each metric:
- FCFE (Free Cash Flow to Equity): Debt has a direct impact on FCFE. When a company has debt, it incurs interest expenses on that debt. These interest expenses represent the cost of borrowing money. In the FCFE calculation, we subtract the interest expense from FCFF to determine the cash flow available specifically to equity shareholders.
The effect of debt on the shareholders is depicted in the below infographics:
If a company has higher levels of debt, it means that it has more interest expenses to pay. Consequently, a larger portion of the cash flow generated by the company will be allocated to interest payments, reducing the amount available to be distributed to equity shareholders. Therefore, higher debt levels generally result in a lower FCFE, as more cash is directed toward servicing the debt.
- FCFF (Free Cash Flow to the Firm): Debt also affects FCFF “indirectly.” FCFF represents the cash flow available to all stakeholders, including equity shareholders and debt holders. When a company has debt, it incurs interest expenses that need to be paid to debt holders.
The presence of debt increases the company’s overall financial obligations, including interest payments and principal repayments. These obligations are deducted from the cash flow generated by the company to arrive at FCFF. As a result, higher levels of debt can reduce the FCFF since a portion of the cash flow is allocated toward debt-related obligations.
Debt has an impact on both FCFE and FCFF. In the case of FCFE, higher debt levels lead to lower cash flow available to equity shareholders after accounting for interest expenses. For FCFF, debt increases the company’s financial obligations, which reduces the overall cash flow available to all stakeholders.
#3. Why Free Cash Flow and Not PAT
In intrinsic value estimation, experts prefer the use of Free Cash Flow instead of PAT. Why? Because free cash flow is a more accurate representation of cash profits available in the hands of the owners.
While net profit (PAT) is a commonly used metric, it can be misleading due to various accounting treatments and non-cash items.
Free cash flow, on the other hand, provides a clearer picture of a company’s financial health by focusing on the actual cash generated.
It accounts for changes in working capital, capital expenditures, and other factors that impact cash flow.
#4. The Role of Free Cash Flow in Valuation
Discounted Cash Flow (DCF) Model: The DCF model is widely used to estimate the intrinsic value of a company. It relies on free cash flow as a critical input. By discounting future cash flows, the DCF model provides a valuation framework that considers the time value of money.
Importance of Free Cash Flow in Intrinsic Valuation: Free cash flow is crucial for estimating a company’s intrinsic value accurately. It reflects the company’s ability to generate sustainable cash flows, which is essential for long-term investors seeking to make informed investment decisions.
#5. Impact of Free Cash Flow For Shareholders
Enhancing Shareholder Value: Positive free cash flow is a significant driver of shareholder value. Companies can utilize free cash flow to enhance shareholder value through initiatives such as dividend payments, share repurchases, or strategic investments that generate long-term growth.
Investor Considerations: Investors should consider free cash flow when making investment decisions. Positive free cash flow indicates a company’s ability to generate cash internally, which may lead to favorable investment opportunities. Conversely, negative free cash flow warrants careful scrutiny, as it may indicate financial instability or a need for external financing.
#6. Warren Buffett’s Perspective on Free Cash Flow
Warren Buffett places great importance on free cash flow in his investment approach. Here’s an explanation of Warren Buffett’s perspective on free cash flow:
- Focus on Cash Flow: Warren Buffett believes that cash flow is a crucial indicator of a company’s financial strength. He pays close attention to the cash a company generates from its operations. It represents the true measure of its ability to generate profits and sustain its business.
- Sustainable Cash Generation: Buffett emphasizes the importance of sustainable cash flow generation. He looks for companies that consistently generate free cash flow. It highlights their ability to generate surplus cash even after meeting all necessary expenses, including reinvestment requirements.
- Long-Term Forecasting: Buffett incorporates free cash flow analysis into his long-term forecasting. By evaluating a company’s historical and projected free cash flow, he aims to assess its long-term earning potential and its ability to generate value over time.
- Capital Allocation: Buffett considers free cash flow in assessing a company’s capital allocation decisions. He looks for management teams that allocate capital wisely. He likes management that uses excess cash to invest in growth opportunities, make strategic acquisitions, or return value to shareholders through dividends and share buybacks.
Buffett’s investment strategy is rooted in value investing, which involves identifying companies with intrinsic value that exceeds their market price. Free cash flow analysis helps him assess the intrinsic value of a company by considering the present value of its future cash flows
Free cash flow is a vital metric that offers valuable insights into a company’s financial health, viability, and potential for generating shareholder value. By understanding the concept, calculating it accurately, and considering its role in valuation, investors can make more informed investment decisions. Free cash flow analysis provides a robust framework for evaluating companies and assessing their ability to generate sustainable cash flows, ultimately contributing to long-term investment success.