Free cash flow (FCF): What it is and what it is for

In the complex world of business finance, one metric stands out as a beacon of financial clarity: free cash flow (FCF). FCF is an essential tool that allows investors, analysts and business leaders to evaluate the financial health of a company and its ability to generate cash after covering its operating expenses and necessary investments. In this article, we will explore in detail what FCF is, how it is calculated, and why it is a critical metric.

What is free cash flow

Free cash flow (FCF) is a fundamental concept in the world of business finance and accounting. It is a metric that evaluates the financial health of a company by measuring the amount of cash available after covering all operating expenses and investments necessary to maintain and grow the business. In other words, FCF represents a company's ability to generate excess cash that can be used to reward shareholders, pay down debt, invest in new projects, or cover any other use that the company's management deems appropriate.

table

Metrics on the state of Tesla's cash flow. Source: TIKR.

What is free cash flow for?

The FCF plays a crucial role in financial decision making for both the company's management and external investors. Below are some of the main uses of the FCF:

  1. Financial health assessment: FCF allows investors and analysts to evaluate a company's ability to generate cash after financing its operations and making capital investments. High FCF generation is typically indicative of a financially strong company.
  2. Company valuation: FCF is used in valuation models, such as the discounted cash flow (DCF) valuation model, to determine the intrinsic value of a company. Investors can use this value as a reference to make investment decisions.
  3. Strategic Decision Making: Company management can use FCF to make strategic decisions, such as deciding whether to reinvest the cash in business expansion or return it to shareholders through dividends or share buybacks.

Benefits of free cash flow

FCF provides several key benefits for both companies and investors:

  1. Financial transparency: It provides a clearer view of a company's true ability to generate cash, compared to profitability measures that may be subject to accounting manipulation.
  2. Efficient resource management: It helps companies efficiently manage their capital investments and maintain a balance between growth and financial stability.
  3. Performance evaluation: It allows investors to evaluate a company's performance over time and compare it to its competitors in the same industry.

Free Cash Flow Limitations

Despite its advantages, the FCF has some important limitations that must be taken into account:

  1. Estimate dependency: Calculating FCF often involves estimates and assumptions, which can lead to some subjectivity in its interpretation.
  2. Seasonal fluctuations: Companies can experience seasonal fluctuations in their FCF, making year-over-year comparison difficult.
  3. It is not infallible: FCF is not the only metric to evaluate a company's financial health. It should be used in conjunction with other financial metrics to get the complete picture.

Free Cash Flow Formula Calculation

The basic formula to calculate FCF is:

formula

Formula for calculating free cash flow (FCF).

Where:

  • EBIT represents earnings before interest and taxes.
  • T is the effective tax rate.
  • Depreciation and Amortization are non-cash expenses that are added to FCF.
  • Change in Net Working Capital reflects changes in current assets and liabilities.
  • Capital Expenditures represent investments in long-term assets.

Example of using the free cash flow formula

Suppose a company has an EBIT of $1,000, an effective tax rate of 30%, $100 of depreciation and amortization, a $50 increase in Net Working Capital, and $200 in Capital Expenses. The FCF calculation would be:

FCF =1,000(1−0.30)+100−50−200=600FCF=1,000(1−0.30)+100−50−200=600

Therefore, in this example, the company has free cash flow of $600 available for various financing options. In short, free cash flow is an essential metric that provides valuable information about a company's ability to generate cash available to investors and other business needs. Its calculation and analysis are essential for making informed financial decisions.


Leave a Comment

Your email address will not be published. Required fields are marked with *

*

*

  1. Responsible for the data: Miguel Ángel Gatón
  2. Purpose of the data: Control SPAM, comment management.
  3. Legitimation: Your consent
  4. Communication of the data: The data will not be communicated to third parties except by legal obligation.
  5. Data storage: Database hosted by Occentus Networks (EU)
  6. Rights: At any time you can limit, recover and delete your information.