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Fundamentally, free cash flow is a measurement that helps to determine the amount of cash generated by a firm after it has paid its capital expenses. Typically, such a measure helps to compute the profitability and financial health of a company. For a more focused analysis, one can use a specific type of FCF like – free cash flow to firm.

What is Free Cash Flow to a Firm?

Free cash flow to firm or simply FCFFcan be described as the cash that is available with the firm owners to pay off their investors. Notably, it is the cash retained for distribution after expenses pertaining to these following are met –

  • Depreciation
  • Taxes
  • Working capital
  • Investments
  • Salaries
  • Cost of goods sold

In other words, when a company has paid off its long-term and short-term financial obligations, the remaining amount of money is referred to as free cash flow to the firm.

It must be noted that FCFF serves as a measurement of a firm’s profitability after it has successfully paid its dues and reinvested in related ventures. Furthermore, it is considered to be a benchmark to compare and assess the firm’s operational performance.

For instance, positive free cash flow to a firm would signify that a firm has retained some portion of its cash after meeting its financial obligations. Alternatively, a negative FCFF signifies that a firm has failed to generate adequate revenue to meet its financial obligations or partake in required investment activities.

Cash Flow to Firm Formula

In a broader sense, free cash flow to the firm formula is represented in 3 distinct ways.

  • Formula with EBIT

In this method the FCFF formula used is –

FCFF = EBIT x (1-tax rate) + Non-Cash Charges + Changes in Working capital – Capital Expenditure

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The formula comes in handy to compute the sum of money available to pay debt and equity holders. As seen from the above formula, earnings generated are not adjusted for taxes and interests.

  • Formula with Net Income

FCFF = Net Income + Depreciation and Amortization + Interest x (1-tax) + changes in Working Capital – Capital Expenditure

Notably, one can easily compute the change in working capital by referring to its current year’s balance sheet.

  • Formula with EBITDA

This method uses the FCFF formula mentioned below –

FCFF = EBITDA x (1-tax rate) + (Depreciation and Amortization) x tax rate + changes in Working Capital – Capital Expenditure

As seen from the above mentioned formulas, to compute FCFF successfully, one needs to be aware of the firm’s EBIT, rate of taxation, depreciation, change in working capital and capital expenses or CAPEX.

Example of Cash Flow to the Firm Calculation

Take a look at the excerpts below to understand the FCFF example more effectively.

Balance Sheet of ACL Limited as on 30th December 2019

Assets 2018 (Amount in Rs. Thousand)2017 (Amount in Rs. Thousand)
Cash3015
Accounts receivable9045
Stock inventory12090
Current asset 240150
Gross Property and Equipment1200900
Accumulated depreciation570420
Total Assets870630
Liabilities 2018 (Amount in Rs. Thousand)2017 (Amount in Rs. Thousand)
Accounts payable6060
Short-term debts6030
Current liabilities 12090
Long-term debts342300
Common stock150150
Retained earnings25890
Total equity and liabilities 870630

Also, as per the company’s income statement,

EBIT = Rs.285

EBITDA = Rs.435

Tax rate = 30%

Net income = Rs.168

Depreciation and amortisation = Rs.150

Capital expenses = Change in the amount of gross PPE

= Rs.(1200 – 900)

=Rs.300

Change in depreciation would be –

Working capital2018 (Rs.)*2017(Rs.)*Difference 
Accounts receivable904545
Inventory stock1209030
Accounts payable6060(-)
Change in working capital75

So, based on the information and free cash flow to firm formula,

FCFFEBIT x (1-tax) + Depreciation and Amortisation + Changes in Working Capital – Capital Expenditure

= 285 x (1-30/100) + 150 75 -300

=-25.5*

*Amount in Rs. thousands

The computation shows a negative value. It indicates that the company ACL Limited has not retained enough cash for reinvestment of dividend payment after paying off its operating and capital expenses.

Importance of Cash Flow to the Firm Calculation 

Undoubtedly free cash flow to the firm is among the most efficient financial indicators of a company’s stock. These following highlight the other prominent examples of the same –

  1. Unlike EPS, FCFF cannot be tweaked by the management. This makes it relatively a more reliable measure of a company’s operational performance.
  2. Increasing free cash flow to the firm is considered to be an excellent indication of future profits. It, in turn, helps growth-oriented investors to identify firms which intend to expand their core business and bring in more profits.
  3. FCFF also helps to ascertain if a company pays off dividends or not. Also, it helps to evaluate if a company is paying a dividend as per its capability or not.
  4. Being an indicator of a dividend-paying company, free cash flow for the firm proves useful for investors who are looking for a company that yields regular dividends.

Limitations of Cash Flow to the Firm Calculation

In the absence of regulating accounting standards, disagreement arises among investors as to which item should be treated as capital expenses and which should be excluded.

A high proportion of FCFF often gives rise to suspicion pertaining to under-reporting of capital expenses and expenses incurred for research and development.

Difference between FCFF and Cash Flow

This table below highlights the fundamental differences between the two –

Parameter Free Cash Flow to FirmCash Flow
Definition It is essentially the cash flow generated through business operations after capital expenses and operating expenses are paid off.It is the net cash and cash equivalent, which is flowing in and out of a company.
Significance It highlights the proficiency of a company to pay off its debts and shareholders. Robust FCFF indicates favourable growth and reinvestment prospects.A positive cash flow suggests a hike in the company’s liquid assets and a higher capability to repay debt and shareholders.
Financial treatmentTypically, one can compute the FCFF with the help of the items recorded in a company’s financial statements.It is essentially reported on a company’s cash flow statement. The cash flow from three sources, namely, investing activities, financing activities and operating activities, is distinctly mentioned.

Therefore, it can be said that free cash flow to the firm is an important metric when it comes to gauging a company’s growth and profitability. It plays a valuable role for business owners, financial analysts and investors alike. However, a company must establish a regulating accounting standard to lower doubts pertaining to financial recordings.

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