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A company’s ability to generate profit comes in handy for projecting a favourable image in front of investors and creditors. They factor in a company’s free cash flow standing to gauge the viability and growth prospect of a business venture.

What is Free Cash Flow?

Free cash flow or FCF can be described as a firm’s cash flow or equity post the payment of all debt and related financial obligations. It serves as a measure of the cash a firm generates or is left with once the amount of required working capital and capital expenditure is accounted for.

In other words, it’s the cash available to repay creditors and reward investors with interest and dividend. The said cash can also be utilised for lowering debt, expanding the scale of business, etc. So, in general, FCF is an effective measurement of a company’s financial health and performance.

Types of Free Cash Flow

In a broader sense, there are 2 types of FCF, namely –

1. Free cash flow to the firm (FCFF)

It indicates the ability of a firm to produce cash which factors in its capital expenditures. Typically, FCFF can be computed with the help of the cash flow generated from operations. Alternatively, one can also use the net income of a firm to compute the same.

It is calculated by using the formula –

FCFF = Cash Flow generating from Operating Activities – Capital Expenditure

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2. Free cash flow to equity (FCFE)

It is the cash flow that is made available for the company’s equity shareholders and is also known as levered cash flow. It represents the sum of money that a firm can distribute to its equity shareholders as dividends. Alternatively, firms can use the money for stock buybacks once all expenses and debts are paid and reinvestments are factored in.

The formula used to compute FCFE is expressed as –

FCFE = FCFF + Net borrowing – Interest amount * (1-tax)

Calculation of Free Cash Flow

One has to refer to the cash flow statement of a company to initiate its free cash flow calculation. Typically, FCF helps to gauge a company’s profitability by excluding its non-cash expenses recorded in the income statement.

Additionally, it includes expenses pertaining to equipment and change in working capital. Notably, interest payments are also excluded from free cash flow.

The FCF formula used to compute the same is as follow –

FCF = Operating cash – Capital expenditure

Example of Free Cash Flow Calculation 

As of 30th March 2020, Stars Industries Limited registered Rs.140,26,300 as net income in their income statement.

ParticularsAmount (Rs.)
Total revenue11,56,93,400
Cost of  revenue6,92,74,700
Operating expense
Selling, general and administrative expenses1,08,27,900
Interest expense7,69,000
Income tax44,46,800
Income from operations 1,41,66,300
Net income1,40,26,300

Also, the financial statement showed the following –

  • Depreciation and amortisation: Rs.18,48,100
  • Current assets: Rs.367,49,700
  • Current liabilities: Rs.256,53,000
  • Fixed assets: Rs.175,59,900

As per the FCF formula,

FCF = Operating Income – Capital Expenditure

= Rs.{14026300 – [(36749700-25653000) + (1848100+ 17559900)]}

= Rs.(14026300 – 37657800)

= Rs.(-30504700)

As per the outcome of the free cash flow calculation, it can be seen that the capital expenditure is more than the available free cash flow. This indicates that in a financial year, Star Industries Limited does not have enough money to pay for expansion or other required operations.

Significance of Free Cash Flow

Free cash flow is considered to be an effective financial ratio which helps to gauge a company’s proficiency and liquidity. A change in free cash flow in a firm often provides a substantial idea about a firm’s performance. Depending upon the change, it either reflects a positive image or a negative image of said firm.

For instance,

a. An increase in FCF

Here a list of reasons which can be deemed responsible for an increase in FCF–

  • Sale of corporate assets.
  • Reduction in capital expenditure or CAPEX.
  • Delay in salary payment.
  • Reduction in marketing and maintenance cost.
  • Closure of a big deal resulting in a sizable deposit.
  • An increase in the bulk of accounts receivable.
  • A delay in the accounts payable.

b. A decrease in FCF

A reduction in FCF can be attributed to these following –

  • An increase in the firm’s working capital.
  • A huge stock order.
  • Investment in equipment.
  • Rapid growth and development.

With that being discussed, one must factor in the advantages and disadvantages of FCF to understand its significance more effectively.

Advantages of Free Cash Flow

Here a list of benefits of FCF 

i. For investors and financial analysts

Investors and analysts use this measurement to identify companies that show a sign of growth.

  • It helps them to determine if a company is paying dividends or not.
  • Enables to gauge if the dividend paid by the company differs from its actual payment capacity or not.
  • Helps to align the cash available with the company’s profitability.

ii.Creditors 

Business ventures require substantial capital to run their business and often seek the assistance of creditors to avail the same. Since the credit amount is huge, the risk involved is also huge for the creditors. However, for creditors –

  • FCF serves as metrics to gauge a company’s repayment capability.
  • Aids their decision of sanctioning a loan amount to a company.

iii.Business partner 

Individuals who intend to join a partnership business model often look for a company that is proficient in terms of sustainable earnings. To gauge the same, they factor in a company’s FCF and estimate the viability of their operations before making a final decision. Rest assured, a company with robust free cash flow is more preferred than others.

Disadvantages of Free Cash Flow

Some free cash flow examples of its restrictions are as follows –

  • Capital expenditure varies from one financial year to another and also among industries. Consequently, one needs to measure the FCF of a company for a long period against the industry’s backdrop.
  • A very high free cash flow may indicate that a company is not investing enough in its business venture.
  • A low CFC does not always mean poor financial standing. It often signifies heavy growth and expansion.

Hence, it can be stated that free cash flow is an important financial unit of measuring a business’s profitability and efficiency. Nonetheless, business owners, investors and analysts must also make use of other financial measurements to avail of a more accurate and relevant financial standing of a company.

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