What is Free Cash Flow?
Free Cash Flow (FCF) is a widely used financial metric used to gauge the company’s cash standing post taking the Capital Expenditure into consideration. Free cash flow is considered in valuation of an investment, entity or project. It is the amount of cash an enterprise is generating after incurring cash costs and cash investments for future growth.
As the name suggests ‘Free’, it is the residual amount of cash left with the company after paying for taxes, inventory, plant and machinery, buildings etc. Investors prefer using this measure due to its effectiveness in assessing business operationally.
It is calculated by deducting Capital Expenditure of the firm from Cash From Operations. CapEx includes the amount spent by the business in maintaining and growing asset base. Another way of calculating FCF requires the below equation.
FCF = Net Profit After Tax + Non-cash Expenses - Changes in Working Capital - Capital Expenditure
While general equation is:
FCF = Cash From Operations - CapEx
Non-cash expenses are included in the income statement, hence included in net income. The accounting principles/standards mandate to incur non-cash expenses like depreciation and amortisation of assets, stock-based payments, goodwill impairments etc.
Since these expenses are non-cash, the total amount is added to net income of business to arrive at core cash generation by the enterprise. Changes in working capital reflect the transactions by a business in its core operations.
Changes in Working Capital = Operating Working Capital (Previous) - Operating Working Capital (New)
The difference between Operating Working Capital (OWC) and Working Capital (WC) is that OWC only includes items related to core operations like payments to suppliers, receipts from customers, inventory, prepaid expenses, deferred revenue. Moreover, cash movement on these items is yet to be realised, therefore it also referred to as Non-cash working capital.
Operating Working Capital = Operating Current Assets - Operating Current Liabilities
Operating current assets comprise accounts receivable, prepayments, inventory and some certain type of current assets in the balance sheet. Likewise, operating current liabilities include accounts payable, deferred revenue, income tax payable, accrued expenses.
Change in working capital allows to determine the movement of operating current assets and liabilities. When the change in working capital is negative, it indicates a change in operating current assets is greater than operating current liabilities – cash was used, thereby reducing Free Cash Flow.
Whereas a positive change in working capital implies operating current liabilities have increased more than operating current assets; cash application was limited, which increases Free Cash Flow.
Moreover, if a change in working capital is negative, it suggests that the business needs further capital to grow as a result its working capital needs are growing. Likewise, when it’s positive, it means the business is able to fund its operations at a lower working capital intensity, possibly due to its bargaining power with suppliers, therefore working capital needs are depleting.
Capital Expenditure is an expenditure that is capitalised on the balance sheet, and expenses are incurred in succeeding years and recorded in income statement. It includes the expenses incurred in maintaining and expanding asset base of the firm.
Cash From Operation is available on the statement of cash flows. It means the net operating cash generation by the business. It includes payments to suppliers, receipts from customers, taxes paid, interest cost etc.
What does FCF imply?
A negative Free Cash Flow is a common feature in small and growing firms since they are at a stage wherein cash burn intensity is higher due to a range of factors, including growing customer base, executing agreements with suppliers, stacking-up inventory, product development, expenses in research and development.
Small and growing enterprises boast high capital needs and often seek funding from markets. Put another way, new businesses monetise their negative cash flows by additional funding from investors or lenders.
But how long investors or lenders can fund the business? It becomes crucial for enterprises to enter a cash flow positive state, which further stems the belief of expected future cash flows from the firm. Raising equity also means a dilution of interest in the company, and excessive use of debt capital increases bankruptcy risk.
When businesses are incurring CapEx, the intent is to generate future cash flows and earnings through the use of asset for purposes like expanding product line, new variants of products, setting up a new factory.
It is also important to study the growth plan of the business and expected need for capital over the investment cycle. Meanwhile, a company with preceding periods of positive FCF can record negative FCF due to high CapEx.
However, if a business is not able to generate FCF over a long term period, it can be a problem for investors. A common investor expects companies to be cash generating machines, which also mean incremental earnings over time. Strong cash flows ensure higher probability of getting dividends.
More on Dividends: Annual Dividend Yield
It often becomes prelude for investors to select companies with a positive FCF. But investors also like businesses with high expectation of future cash flows due to numerous factors, including position in the industry, disruptive technology, innovative products, first-mover advantage.
FCF of a firm also indicates the ability of the firm to meet its obligations like interest payments and potential need of capital over the near-term.
What are the types of Free Cash Flows?
Free Cash Flows to Equity: Free Cash Flows to Equity is calculated by adding issued debt and repaid debt to Free Cash Flow. It gives the amount of cash available with the company for shareholders and doesn’t indicate the amount distributed to shareholders.
Free Cash Flow to the Firm: Free Cash Flow to the Firm refers to the amount of funds available for the shareholders and lenders/bondholders after incurring the cost of doing business, improvements to assets (capital expenditures), and investments in working capital.