In a particular financial year, a company incurs substantial expenses to maintain its capital assets as well as support its operations. The amount generated after accounting for such expenses is given by a company’s Free Cash Flow for a particular year. The Free Cash Flow of a firm is utilised to meet certain requirements and can be broadly classified into Free Cash Flow to the Firm and Free Cash Flow to Equity.
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What is Free Cash Flow to Equity?
Free Cash Flow to Equity or FCFE is a measurement of a company’s cash that is available for distribution among said company’s shareholders. This amount is calculated after all of the company’s expenses, debts, and reinvestments are accounted for, and alongside FCFF can be utilised to evaluate a company’s financial health.
In fact, over the years, the FCFE method of determining a company’s value has garnered popularity among analysts over the Dividend Discount Model (DDM). That’s because –
- If a company does not pay out dividends, it can be difficult to calculate the amount available for equity stockholders using DDM. Alternatively, using the FCFE method helps to calculate this amount with ease, even if the dividend is not paid out to the company’s shareholders.
- FCFE method is also a reliable metric for determining if a company utilises its free cash flow to equity or any other means for financing stock repurchases and dividend payments.
Thus, FCFE can be considered much more definitive in terms of effectively gauging a company’s financial standing.
Calculation of Free Cash Flow to Equity
The calculation of a company’s FCFE can be done by utilising several formulae. Following is an analysis of the same utilising the net income formula.
Using net income –
The Free Cash Flow to Equity Formula utilising net income is given by –
FCFE = Net Income + Depreciation & Amortisation + Changes in Working Capital + Capital Expenditure + Net Borrowings
To understand this calculation better, it is crucial to analyse each component utilised in the formula.
|Depreciation & amortisation||
|Changes in Working Capital||
Now that the components in the FCFE formula have been examined, the following Free Cash Flow to Equity example can help bolster one’s understanding of FCFE calculation using net income –
Following are a few information gathered from Company X’s Income Statement and Balance Sheets for the year 2019 and 2020 –
|Particulars||2020 (in Rs. Lakh)||2019 (in Rs. Lakh)|
|Depreciation & Amortisation||15||10|
|Short term debt||40||30|
|Long term debt||30||20|
The company’s net income for 2020 is given by Rs.200,00,000.
- Net income is Rs.200 lakh
- Depreciation & amortization is Rs.15 lakh
- Changes in working capital –
- Difference in current assets = 100-150 = -50
- Difference in current liabilities = 30-30 = 0
- Thus, change in WC = -50-0 = -50
- Capital expenditure is 250 – 200 = 50
- Net borrowings –
- Difference in long term debt = 10
- Difference in short term debt = 10
- Thus, net borrowings = 20
Therefore, FCFE = Rs.(20000000 + 1500000 – 5000000 – 5000000 + 200000)
Thus Company X’s FCFE is positive, denoting that its capital structure is stable.
Apart from this, a company’s FCFE can also be computed by –
- Using FCFF
FCFE = FCFF + Net Borrowings – [interest x (1 – tax)]
- Using EBIT
FCFE = [EBIT – (Interest paid + Taxes paid)] + Depreciation & amortisation + Net Borrowings + Capital Expenditure + Change in Working Capital
From the above mentioned FCFE formulas, it can be gathered that a company’s Free Cash Flow to Equity can only be computed if one has access to its balance sheet and income statement for a particular year.
Why is it Important to Compute FCFE?
FCFE is the most relevant metric that potential investors should analyse before deciding to invest in a company’s shares. While a company might have very high cash flow, most of it can go towards settling existing debts, leaving a minuscule percentage to be distributed among shareholders.
Conversely, a company might be making higher dividend payments despite having a low FCFE. In this case, the company is either issuing new securities or making the dividend payouts with existing capital or debt. Such a situation also translates to an unfavourable proposition for the company’s prospective investors.
Thus, one should mandatorily analyse a company’s FCFE before making a decision to invest in its shares.
What does Negative FCFE Imply?
Under certain circumstances, a company’s FCFE can also be negative. Such a situation can arise due to either of the following factors –
- The company in question’s net income is running at negative, and it is suffering huge losses.
- A change in working capital resulting in a cash outflow.
- Said company makes a sizable capital expenditure during a particular financial year.
- The company decides to settle its debts, which results in substantial cash outflow.
Thus, negative FCFE does not always imply that the company is suffering losses. It is simply indicative of the fact that the company will have to raise new equity in the near future.
Differences between FCFE and FCFF
The principal difference between these two categories of cash flow is that FCFF denotes the cash that is available to all of a company’s investors, once its operating expenses incurred in a particular year are paid off. In this regard, a company’s investors include stockholders, preferred stockholders, bondholders and others.
On the other hand, FCFE only denotes the cash that is available for equity shareholders once all of the company’s expenses have been paid off.
Both these variations of free cash flow are crucial in determining a company’s expected performance.