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What is Free Cash Flow in Corporate Finance?
Free Cash Flow (or, FCF) is a term widely used in Corporate Finance. It is the extra cash flow available with the company after deducting the working capital expenditures and the expenses towards fixed assets. It is significant because it shows the flexibility of a company to meet newer expenditures or to allow more payment to security holders and creditors without affecting the operations of the company. FCFs are of interest to the creditors, lenders, borrowers and financial managers, as it is related to the financial wellbeing of a company.
How to Calculate Free Cash Flows?
FCF can be calculated in a number of ways depending on the availability of resources and financial data. A common method of calculation involves taking the earnings before interest and taxes (EBIT), adding depreciation and amortization, and then subtracting taxes, changes in working capital, and capital expenditure (CAPEX).
Simply written, it is,
$$\mathrm{FCF\: =\: EBIT \:+\: Depreciation \:\&\: Amortization \:-\: Taxes \:-\: Changes\: in\: Working\: Capital \:-\: CAPEX}$$
When net profit and tax rates are available, the Free Cash Flow can be measured by the following formula −
$$\mathrm{FCF\:=\:Net Profit\:+\:Interest \:Expense\:-\:Net \:Capital \:Expenditure\:-\:Net \:Changes\: in \:Working \:Capital\:-\:Tax \:Shield\: on\: Interest \:Expense}$$
Where,
$\mathrm{Net\:Capital\:Expenditure\:=\:CAPEX\:-Depreciation\:\&\:Amortization}$
$\mathrm{Tax\:Shield\:=\:Net\:Interest\:Expense\:\times\:Marginal\:Tax\:Rate}$
When Profit after Tax (PAT) and Debt/Equity are available, we can use the following formula to calculate the Free Cash Flow −
$$\mathrm{FCF\:=\:PAT\:+\:Changes\:in\:Capital\:Expenditure\:\times(1-d)\:+\:Depreciation\:\&\:Amortization\:\times\:(1-d)\:-\:Changes\:in\:Working\:Capital\:\times\:(1-d)}$$
Where $d$ is debt-to-equity ratio.
Difference between FCF and Net Income
There are two major differences between Free Cash Flow and Net Income −
The first is that the capital goods accounting, net income subtracts depreciation, while FCF considers the last period's capital purchase. The advantage of FCF due to this is that spending is recorded in current dollars. The disadvantage is that, the capital investments being the responsibility of managers, it can be sporadic. In the case of Net Income, the deduction of depreciation is an advantage, while the disadvantage is that there is a mismatch in prices of assets when smoothed charges are applied.
The second difference is that, FCF makes adjustments to net working capital changes, while the net income does not. In general conditions, the company will require more capital to finance labor and profitability in the growing receivable balance.
Conclusion
Free Cash Flows show the real financial conditions of a firm. As the measurements are made in real value terms, FCFs show a clearer picture of the health of a company. FCFs are widely used in corporate finance to adjudge the value of a firm and its ability to withstand risks that may arise from time to time.
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