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Free cash flow (FCF) is more valuable than the net profit (PAT) of a company. We will see how. To understand it, we will use a hypothetical example and calculate the free cash flow for an individual.

Suppose you won a prize in a car rally. The gift is payable in cash worth Rs.5,00,000. But it will be paid in two installments. The first installment of Rs.3,00,000 will come in the current year, and the balance of Rs.2,00,000 will come the next year.

In your personal financial reports, you can show Rs.5,00,000 as net profit for the current year. But your cash in-flow in the current year will be only Rs.3,00,000. 

  • You’ve paid in cash Rs.2,00,000 towards the modification of the car to enhance its performance. It will your cost of CAPEX. 
  • You’ve also paid in cash Rs.1,50,000 towards refueling and general maintenance of the car.

Considering the above data, let’s calculate your free cash flow:

The free cash flow in this example is negative. Though the company looks profitable in the P&L account, a negative FCF will yield it only zero intrinsic value. The value investors like Warren Buffett will stay away from such companies. 

What is Free Cash Flow (FCF)?

Free cash flow is really free cash in the hands of the owners of the company. It is free from any immediate obligations of the company. If the owners want, all of it can be paid as dividends.

Why FCF is referred to as free? Because it is the extra cash left with the company, at the end of the financial year, after payment of all due current liabilities, including interest (in case of FCFE), and also taxes.

FCF helps the investors to analyze the profitability of the company by removing all non-cash transactions.

Significance of Free Cash Flow?

When shareholders mention free cash flow, they are actually referring to Free Cash Flow to Equity (FCFE). We will know more about the two types of FCF in this article. But before that let’s understand the significance of FCFE. 

FCFE is the owner’s cash that is free from all obligations. The owners (shareholders) are free to retain the FCFE or pay a part of it as dividends.

Retained FCFE can be used for clearing debt, strengthing working capital, shares buyback, increasing R&D funding, taking up new marketing plans, acquisitions, buying investments, etc. All these activities are done to enhance the shareholder value over time. 

For shareholder’s, the bigger will be the quantum of FCFE, the higher will be their returns.

  • In short term, they will earn more in terms of dividends.
  • In long term, FCFE’s reinvestment will increase the company’s market share, hence higher returns for its shareholders. 

Types of Free Cash Flow

There are two types of people who invest in a company, borrowers and equity holders. Borrowers lend money (debt) to a company for a fixed return called interest. Equity holders lend money for a stake in the company’s earnings.

Free Cash Flow is free cash available for distribution to both borrowers and equity holders. 

There are two variations on FCF, FCFF and FCFE. 

When we generally use the term FCF, we are referring to Free Cash Flow To Firm (FCFF). FCFF caters to both borrowed and equity holders. Free Cash Flow To Equity (FCFE) caters to only equity holders. 

The relationship between FCFF and FCFE can be seen in this formula:

FCFE = FCFE + Net Borrowed Debt – Interest * (1-tax rate)

Parameters FCFF FCFE
Description It is free cash available for both borrowed 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.  FCFF considers the effect of debt on the free cash available to the company. It adds new debt to FCFF, substracts principal, and interest paid off the existing loans.  
What discount rate to be considered in intrinsic value estimation using DCF Model Weighted Average Cost of Capital (WACC = Cost of Debt + Cost of Equity) Only Cost of Equity
Preference of equity investor NO YES

Free Cash Flow & Intrinsic Value

FCF is used to estimate the intrinsic value of a company. Discounted Cash Flow (DCF) is the financial model using which intrinsic value estimation is donem.

In the estimation of intrinsic value, the correct calculation of free cash flow is essential. Accurate will be the free cash flow estimation, precise will be the intrinsic value estimation.

In this article, we will learn about how to calculate free cash flow of a company. 

How To Calculate Free Cash Flow?

There are two ways to calculate free cash flow of a company. First is by using the numbers in the cash flow report. Second is from the balance sheet and profit and loss account. 

Analysts prefer the use of cash flow report because, it deals only in cash. It removes the account receivables because it is non-cash item. Similarly, all non-cash expenses which are still not paid, or has been paid is advance are removed. 

As one is calculating FCF, the numbers appearing in the cash flow report, which is net of non-cash items, is justified. 

From Cash Flow Report

Calculate Free Cash Flow From Cash Flow Statement

Look into the cash flow report and all the numbers required to calculate FCF are available on a platter. Hence, the best way to calculate the FCF is by downloading the cash flow statement from the company’s website.

The first required number is Cash PBIT. This number is inclusive of a interest expense and net of actual cash tax paid. 

Cash PBIT = PAT + (Tax Expense – Tax Paid) + Interest

The interest expense is added back to PAT is because of two reasons. 

  • First, interest is not an operating expense. It will be visible under the head cash flow from financing activities
  • Second, to calculate FCFE, we need actual interest paid in cash and not the total interest expense shown in the P&L account. 

Once the Cash PBIT is known, cash flow statement displays the net cash generated by operating activities. This is done after adjusting the cash PBIT for any non-cash transactions. 

After all non-cash items have been adjusted, what we have is called net cash flow from operating activities

Now, the below formula can be used to calculate FCFF and FCFE:

FCFF = Net Cash From Operating Activities – CAPEX

FCFE = FCFF + Net New Debt – Interest Paid

The value of Capex and the actual interest paid are clearly defined in the cash flow statement. Suggested Reading: How to read cash flow report.

In case, cash flow report available is not as detailed, the balance sheet and P&L reports can be used to calculate FCF. 

P.Note: I will like to add here that, cash flow reports download from the company’s website are detailed. But some financial websites like economitimes, moneycontrol, etc presents non-detailed cash flow statements of companies. 

From Balance Sheet and P&L A/c

There are cases where the company has reported a positive PAT in P&L account but upon calculation, its FCF came negative. Negative FCF means, its intrinsic value will be zero.

In intrinsic value calculation, experts prefer the use of Free Cash Flow instead of PAT. Why? Because free cash flow is more accurate representation of cash profits available in the hands of the owners.

The below schematic representation highlights the difference between Net Profit (PAT) and Free Cash Flow (FCFF & FCFE).

Calculate Free Cash Flow From Balance Sheet & Income Statement

FCF Formula

Free Cash Flow FCFF FCFE Formula

Allow me to explain each of the ingredients of the Free Cash Flow formula.

1. Net Profit (PAT)

PAT is the estimated income after adjusting all expenses. These 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, called free cash flow.

The strategic expenses could be like prepayment of debt, funding Capex, funding of the increase in working capital, etc.

2. Depreciation & Amortisation (D&A)

This is a non-cash expense reported in company’s income statement. It is the adjustment of Capital Expenditures (CAPEX) already made by the company in the past.

What does it mean? It means, 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 flow 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 Year 2021. The life of the purchased asset is 8-Years. So the company can book the total CAPEX in all of the next 8 years. Hence, in Yr-2022 it will book a 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 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.

3. Interest Expense

In FCFF, we are calculating the free cash flow available to all type of investors of the company (borrowers and equity holders). Hence, the effect of debt is not taken into consideration.

How debt effects the company? In three ways, increase in cash flow, increase in interest expense, and tax savings due to interest paid.

In calculation of FCFF, the three effects of debt are not considered. Why? Because here we want to know the free cash available for both borrowers and shareholders.

4. Increase in Working Capital

Let’s first know about the components of working capital’s.

  • Current Asset (CA): Total liquid assets which can be converted into cash in next one 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 next one 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: We are in year 2020. Suppose a hypothetical company ABC reported Rs.100 Cr in current asset (CA) in FY2019. The company also reported an immediate obligation of Rs.75 Cr in 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 2019. Hence, what is available for 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 as working capital. This is the net available fund generated by the company’s operations in year 2019, that can be used to fund the operational needs in year 2020.

Suppose there is another hypothetical company XYZ which reported Rs.120 Cr. in current asset (CA) in FY2019, and Rs.130 Cr in current liability (CL). As CL is more than CA, hence its working capital will be in negative.

WC (-Rs.10 Cr) = CA (Rs.120 Cr) – CL (Rs.130 Cr)

A negative working capital means, in 2019 the company has not generated enough cash to fund its current liabilities. As a result, for 2020 the company starts with zero WC.

Moreover, in 2020 it must also ensure enough current assets to take care of current liability deficit for 2019, and to meet the forthcoming current liabilities requirement for 2020.

Effects of Change in WC

How change in WC (year on year), effects the company’s Free Cash Flow?

  • Increase in WC is Positive: it is like 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.
  • Increase in WC is negative: it is like an indication that the company wants to keep less liquid assets for its forthcoming operation needs. Hence, this amount gets added into the reported PAT.

5. Capital Expenditure (CAPEX)

Capex is the money which a company has spent to expand & upgrade its asset base. In this process they either buy new assets (expansion), or they 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 company’s P&L A/c as it is booked. But CAPEX cost is booked in a staggered way, as depreciation, throught out the life of the asset.

If one does not have access to the company’s cash flow repot, 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

In FCFE, we are calculating the free cash flow available exclusively for the shareholders. Hence, the effect of debt is must also be taken into consideration.

When we will calculate FCFE, the effect of debt must be considered. Check here.

What will be the effect of debt for the shareholders? Check the below infographics:

Effect on cash due to debt for shareholders

Example: Free Cash Flow Calculation

In this example, we will use an example stock Reliance Industries (RIL) and calculate its free cash flow. First, we will collect the numbers from its financial statement. I’ve used the database of moneycontrol to fetch the data for RIL.

Conclusion

There is a reason why Warren Buffett refers to Free Cash Flow as Owners Income. This is that money which is the real profit for the owners of the company.

After undertaking all necessary expenses required to operate and keep the business competitive for long term, what is left in the hands of the owners is called free cash flow.

But to calculate intrinsic value of a company, calculating only one year’s free cash flow is not enough. Warren Buffett will study at least last 10 years financial data to forecast future cash flows of a company.

I’m sure not many has the time to dig so deep into the financial statement of companies. My stock analysis worksheet can help you. It estimates future cash flows, and intrinsic value of a company based on last 10 years data.




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