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What is Free Cash Flow to Firm (FCFF)
The amount by which a company's operating cash flow exceeds its working capital requirements and expenditures on fixed assets is referred to as free cash flow to firm (FCFF) (known as capital expenditures). It is the portion of a company's cash flow that can be extracted and distributed to creditors and stockholders without causing disruptions in the company's operations or financial position. The ratio serves as a measure of financial flexibility for the company and is of interest to holders of equity, debt, preferred stock, and convertible securities of the company as well as potential lenders and investors.
Different approaches to calculating free cash flow can be used depending on the audience and data available. In most cases, earnings before interest and taxes are calculated by taking earnings before interest and taxes, adding depreciation and amortization, and subtracting taxes, changes in working capital, and capital expenditure. A number of refinements and adjustments may also be implemented, depending on the target audience, in order to try to eliminate distortions.
Because free cash flow takes into account the purchase of capital goods as well as changes in working capital, free cash flow may differ from net income in some situations.
Formulas of FCFF
Free Cash Flow Formula from Net Income
FCFF starts with net income, which is a metric that is calculated after deducting taxes and interest. Following that, we deduct any relevant non-cash expenses, such as depreciation and amortization. If you think about it, calculating the D&A and change in NWC adjustments to net income is similar to figuring out how much money is coming in and going out of the company's operations in the cash flow statement.
The interest expense is then subtracted from the total because it only applies to lenders. Aside from that, the "tax shelter" associated with interest must be re-added as well (i.e., the tax savings). The interest on debt reduced taxable income; therefore, the interest must be multiplied by (1 – Tax Rate) in order to calculate taxable income.
It has the effect of removing the impact of interest from taxes, which is the goal of the NOPAT legislation (i.e., capital-structure neutral).
To be clear, the FCFF is available to both creditors and equity holders. As a result, we are working toward calculating figures on a "before interest" basis, as we are starting from the CFO's perspective (i.e., an after-tax metric).
Consequently, to arrive at a value that is representative of all sources of capital, we subtract the interest expense amount, which has been adjusted to account for the fact that interest is tax deductible.
Now that net income has been boosted by D&A and is no longer subject to debt-related payments (and their consequences), we can proceed with deducting the re-investment requirements, which include the change in NWC and CapEx.
FCFF= Net Income + Depreciation & Amortization +Interest Expense (1 – Tax Rate) – Capital Expenditures – Net Change in Working capital
Free Cash Flow Formula from Cash from Operations
The cash flow from operations is the starting point for calculating FCFF (CFO). CFO section: The "bottom line" from the income statement is presented first, which is then adjusted for non-cash expenses and changes in working capital before being presented on the cash flow statement.
Keep in mind, however, that pulling the CFO figure from the financial statements without first confirming that the non-cash charges are indeed related to the core operations and are recurring should be avoided at all costs.
After that, we add back the tax-adjusted interest expense, using the same logic as in the previous formula, to get the final result.
CapEx is subtracted from the total in the final step because it represents a required cash outlay. There is no need to deduct the change in NWC this time around because the CFO has already taken it into consideration previously. However, capital expenditures (CapEx) are included in the cash flow from investing section and were not previously accounted for.
FCFF = Cash Flow from Operations + Interest Expense (1-Tax Rate) – Capital Expenditures
Free Cash Flow Formula from EBIT
In order to calculate FCFF from earnings before interest and taxes (EBIT), we must first adjust EBIT for taxation before continuing. Notably, earnings before interest and taxes (EBIT) is an unlevered profit measure because it is above the interest expense line and does not include outflows specific to a single group of capital providers (e.g., lenders).
The tax-affected EBIT is also referred to as the following terms:
EBIAT: Earnings Before Interest After Taxes
NOPAT: Net Operating Profit After Taxes
Following that, non-cash items such as depreciation and amortization (D&A) are subtracted because they do not represent actual cash outflows. However, in order to be included in the recall, each item must be recurring and part of the core operations – as a result, not all non-cash items are returned (e.g., inventory write-downs).
Next, capital expenditures (CapEx) and changes in net working capital (NWC) are subtracted from the total. Capital expenditures (CapEx) are the line item that should be accounted for in the cash from investing section of the balance sheet. The justification for this is that capital expenditures, particularly maintenance capital expenditures, are required for operations to be sustainable in the long term.
The following is the relationship between the change in net working capital and free cash flow:
Increase in Net Working Capital → Less FCF
Decrease In Net Working Capital → More FCF
If the value of a current operating asset such as accounts receivable (A/R) increases, it indicates that the company is less efficient at collecting cash from customers who paid on credit – in effect, the amount of cash on hand decreases.
If a current operating liability, such as accounts payable (A/P), increases, it indicates that the company has not yet paid suppliers or vendors for due payments – while the payment will still be made out eventually, the cash is currently in the possession of the company. Capital expenditures and increases in net working capital (NWC) both represent cash outflows, which means that less free cash flow is available post-operations for payments related to debt servicing interest, debt amortization, and other obligations.
Combining all of this information, the following formula has been developed:
FCFF = EBIT*(1 – Tax Rate) + Depreciation & Amortization – Δ Net Working Capital – Capital Expenditure
Understanding Free Cash Flow to the Firm (FCFF)
Following the payment of all business expenses, investment in current assets (e.g., inventory), and investment in long-term assets, FCFF represents the cash available to investors (e.g., equipment). When calculating the amount of money left over for investors, the FCFF considers bondholders and stockholders to be beneficiaries.
It is possible to use the FCFF calculation to gauge the operations and performance of a company. In calculating FCFF, all cash inflows in the form of revenues are taken into account, as are all cash outflows in the form of ordinary expenses, as well as all cash reinvested to grow the business. The money that remains after all of these operations has been completed represents a company's FCFF.
The amount of free cash flow generated by a company is arguably the most important financial indicator of the value of its stock. Stock prices are considered to be the sum of the company's expected future cash flows, which is represented by the value of its stock. Stocks, on the other hand, are not always priced correctly. When investors understand a company's FCFF, they are better equipped to determine whether a stock is fairly valued. A company's ability to pay dividends, conduct share repurchases, or repay debt holders is also represented by the FCFF. Any investor considering investing in a company's corporate bond or public equity should first investigate the company's FCFF.
A positive FCFF value indicates that the company has cash left over after expenses have been paid. A negative value indicates that the company has not generated enough revenue to cover its costs and invest in new projects and technologies. The latter scenario necessitates a more in-depth investigation to determine why costs and investment exceed revenues. It could be the result of a specific business purpose, such as in high-growth technology companies that make consistent outside investments, or it could be a symptom of financial difficulties in the company's overall operations.
Uses of FCFF
The expenditures for asset maintenance represent a portion of the capital expenditures reported on the Statement of Cash Flows. It must be kept separate from expenditures for the purpose of growth and development. According to GAAP, there is no requirement for this split, and it is not audited. Management has the option of disclosing or not disclosing maintenance capex. So this input to the calculation of free cash flow may be subject to manipulation or may require estimation on the part of the analyst. Because it may be a large number, the uncertainty surrounding maintenance capex is the basis for some people's dismissive attitude toward 'free cash flow.'
One of the problems with the maintenance capex measurement is that it has an inherent 'lumpiness,' which makes it difficult to interpret. Spending money on capital assets that will last for decades is inherently infrequent, but when it does occur, it is extremely expensive. In turn, the amount of 'free cash flow' available will vary greatly from year to year. There will be no 'normal' year that can be expected to be repeated in the following years. For businesses with predictable capital expenditures, free cash flow will (over the long term) be approximately equal to earnings.
Limitation of FCFF
In the absence of governing accounting standards, there is disagreement among investors as to which items should be treated as capital expenses and which should be excluded from the calculation of capital expenses.
Because a high proportion of FCFF is used, there is often concern about underreporting of capital expenditures as well as expenses for research and development.
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