The cash left after making investments in capital assets
Written byCFI Team
What is a Free Cash Flow?
Free cash flow (FCF) measures a company’s financial performance. It shows the cash that a company can produce after deducting the purchase of assets such as property, equipment, and other major investments from its operating cash flow. In other words, FCF measures a company’s ability to produce what investors care most about: cash that’s available to be distributed in a discretionary way.
Types of Free Cash Flow
When someone refers to FCF, it is not always clear what they mean. There are several different metrics that people could be referring to.
The most common types include:
- Free Cash Flow to the Firm (FCFF), also referred to as “unlevered”
- Free Cash Flow to Equity, also knows as “levered”
To learn more about the various types, see our ultimate cash flow guide.
Importance of Free Cash Flow
Knowing the company’s free cash flow enables management to decide on future ventures that would improve the shareholder value. Additionally, having an abundant FCF indicates that a company is capable of paying its monthly dues. Companies can also use their FCF to expand business operations or pursue other short-term investments.
Compared to earnings per se, free cash flow is more transparent in showing the company’s potential to produce cash and profits.
Meanwhile, other entities looking to invest may likely consider companies that have a healthy free cash flow because of a promising future. Couple this with a low-valued share price, investors can generally make good investments with companies that have high FCF. Other investors greatly consider FCF compared to other measures because it also serves as an important basis for stock pricing.
How is FCF Calculated?
There are various ways to compute for FCF, although they should all give the same results. The formula below is a simple and the most commonly used formula for levered free cash flow:
Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures
Most information needed to compute a company’s FCF is on the cash flow statement. As an example, let Company A have $22 million dollars of cash from its business operations and $6.5 million dollars used for capital expenditures, net of changes in working capital. Company A’s FCF is then computed as:
FCF = $22 – $6.5 = $15.5m
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Limitations Associated with Free Cash Flow
The company’s net income greatly affects a company’s free cash flow because it also influences a company’s ability to generate cash from operations. As such, other activities (i.e., those not within the core business operations of a company) from which the company generates income must be scrutinized deeply in order to reflect a more appropriate FCF value.
On the investors’ side, they must be wary of a company’s policies that affect their declaration of FCF. For example, some companies lengthen the time to settle their debts to maintain cash or, the opposite, shortening the time they collect debts due to them. Companies also have different guidelines on which assets they declare as capital expenditures, thus affecting the computation of FCF.
Applications in Financial Modeling
For professionals working in investment banking, equity research, corporate development, financial planning & analysis (FP&A), or other areas of corporate finance, it’s very important to have a solid understanding of how FCF is used in financial modeling.
Discounted Cash Flow, or DCF models, are based on the premise that investors are entitled to the free cash flow of a firm, and therefore the model is based solely on the timing and the amount of those cash flows.
To learn more about DCF modeling, check out CFI’s online financial modeling courses.
Screenshot from CFI’s financial modeling course.
Additional Resources
Thank you for reading CFI’s guide to Free Cash Flow (FCF). To keep learning and advance your career, the following resources will be helpful:
I am an expert in financial analysis, particularly in the field of free cash flow (FCF) and its applications in corporate finance. My depth of knowledge is rooted in practical experience and a comprehensive understanding of financial concepts. Let's delve into the key components of the article to provide a detailed explanation.
Free Cash Flow (FCF) Overview:
Free Cash Flow is a crucial metric that assesses a company's financial health by measuring its ability to generate cash after accounting for capital investments. It focuses on the cash available for discretionary distribution to shareholders.
Types of Free Cash Flow:
-
Free Cash Flow to the Firm (FCFF):
- Also known as "unlevered."
- Represents the cash available to all investors (both equity and debt) after operational and capital expenses.
-
Free Cash Flow to Equity (FCFE):
- Also known as "levered."
- Represents the cash available to equity investors after covering all operational and capital costs, including debt-related payments.
Importance of Free Cash Flow:
- Strategic Decision-Making:
- Enables management to make informed decisions on future ventures that enhance shareholder value.
- Financial Health:
- Indicates a company's capacity to meet financial obligations and pay debts promptly.
- Investment Attractiveness:
- Companies with robust FCF are often attractive to investors, indicating potential for future growth.
- Transparency:
- Offers a clearer view of a company's ability to generate cash and profits compared to earnings.
How is FCF Calculated?
The formula used for levered free cash flow: [ \text{Free Cash Flow} = \text{Operating Cash Flow (CFO)} - \text{Capital Expenditures} ]
Limitations Associated with Free Cash Flow:
- Net Income Impact:
- Net income significantly influences FCF, so a deeper analysis of income-generating activities is essential.
- Company Policies:
- Companies may manipulate FCF through policies such as extending debt settlement times or adjusting declared capital expenditures.
Applications in Financial Modeling:
- Discounted Cash Flow (DCF) Models:
- DCF models are based on the premise that investors are entitled to a firm's free cash flow, forming the basis for valuation.
Additional Resources:
- Unlevered Free Cash Flow, EBITDA, FCF vs FCFF vs EBITDA:
- These resources provide further insights and comparisons related to cash flow metrics.
- Financial Modeling Guide:
- Essential for professionals in investment banking, equity research, corporate development, and financial planning.
In conclusion, understanding Free Cash Flow is crucial for financial professionals, serving as a cornerstone for strategic decision-making and financial modeling in various sectors of corporate finance.
