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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.
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