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.
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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 –
- Working capital
- 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
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)|
|Gross Property and Equipment||1200||900|
|Liabilities||2018 (Amount in Rs. Thousand)||2017 (Amount in Rs. Thousand)|
|Total equity and liabilities||870||630|
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)
Change in depreciation would be –
|Working capital||2018 (Rs.)*||2017(Rs.)*||Difference|
|Change in working capital||75|
So, based on the information and free cash flow to firm formula,
FCFF = EBIT x (1-tax) + Depreciation and Amortisation + Changes in Working Capital – Capital Expenditure
= 285 x (1-30/100) + 150 75 -300
*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 –
- Unlike EPS, FCFF cannot be tweaked by the management. This makes it relatively a more reliable measure of a company’s operational performance.
- 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.
- 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.
- 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 Firm||Cash 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 treatment||Typically, 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.