Free cash flow is defined as the net balance begot from the operations of a business across a specific financial period. In basic terms, free cash flow can be described as the amount of money that is freely available after paying all financial commitments or operating costs after a specific financial period.
To many people, free cash flow (FCF) provides little clarity since there is a blurred understanding of FCF in mainstream economics. The two main types of free cash flow are as stated below.
- Free cash flow to the firm
- Free cash flow to equity
Free Cash Flow to the Firm (FCFF)
Also called “unlevered,” FCFF is the amount of money available for spending after deducting taxes, working capital, investments, and depreciation. FCFF is a robust benchmarking method used to analyze a company’s financial health. FCFF measures a firm’s profit after expenses and reinvestments. Free cash flow to the firm represents the cash available for expansion after a company deducts all its financial obligations.
Numerous methods are used to calculate FCFF, but they are all supposed to yield the same result. The most commonly used formula is highlighted below.
NI + NC + (I × (1 – TR)) – LI – IWC = FCFF
- NC = Non-cash charges
- NI = Net income
- TR = Tax Rate
- I = Interest
- LI = Long-term Investments
- IWC = Investments in Working Capital
Free Cash Flow to Equity (FCFE)
FCFE basically determines the amount money available for equity shareholders after all expenses, debt, and reinvestments have been paid. FCFE comprises net income, working capital, capital expenditures, and debt. Financial inquisitors commonly utilize the FCFE metric to determine the practicality and benefits of a given company. When properly applied, the FCFE metric exposes whether dividend payments and stock purchases are paid to FCFE or other forms of financing. The most commonly used formula for calculating FCFE is shown below.
V equity= (r−g) FCFE
- FCFE = expected FCFE for next year
- R = cost of equity of the firm
- V equity = value of the stock for that day
- G = growth rate in FCFE for the company
Most importantly it is vital to understand the pros and cons of free cash flow. It is an effective method that helps stakeholders and shareholders understand how the business is faring. Free cash flow discloses relevant information about the company’s expenditure and the numerous methods that are used to secure the company’s investments.
Benefits of Free Cash Flow
A good FCF analysis provides relevant information to lenders and shareholders. It gives surety to lenders that the company is capable of servicing its debt. FCF is a vital measurement method that shows a company’s management quality. FCF shows the company how much is available for investment and how much can be allocated to shareholders.
Another important feature of a good FCF is that it informs the company and stakeholders about the future performance of the company. A good company that generates a positive FCF every financial year is a good prospect for investors, shareholders, and the company.
Constraints of Free Cash Flow
Since FCF applies the entire cost of capital expenditure where the property is acquired instead of spreading it over different periods as the main financial statement, this can give a wrong impression about a company’s financial position. Another aspect that negatively affects FCF is volatility. In cases with repeated capital expenditures over recurrent periods, especially after a few years, FCF can be volatile compared to net income.
FCF ignores the cost of debt services. Thus it may not necessarily reflect the ability of a company to manage its debts. It is also not a proper method when involving big companies that record huge debts every year.