Free-cash Flow

[Yi Pressimone]

Freecash flow is not a line item listed in financial statements. Instead, it has to be calculated using line items found in financial statements. The simplest way to calculate free cash flow is by finding capital expenditures on the cash flow statement and subtracting it from the operating cash flow found in the cash flow statement.

Net cash flow takes a look at how much cash a company generates, which includes cash from operating activities, investing activities, and financing activities. Depending on if the company has more cash inflows or cash outflows, net cash flow can be positive or negative. Free cash flow is more specific and looks at how much cash a company generates through its operating activities after taking into account operating expenses and capital expenditures.

The first approach uses cash flow from operating activities as the starting point and then makes adjustments for interest expense, the tax shield on interest expense, and any capital expenditures (CapEx) undertaken that year.

The second approach uses earnings before interest and taxes (EBIT) as the starting point, then adjusts for income taxes, non-cash expenses such as depreciation and amortization, changes in working capital, and CapEx.

While a healthy FCF metric is generally seen as a positive sign by investors, it is important to understand the context behind the figure. For instance, a company might show high FCF because it is postponing important CapEx investments, in which case the high FCF could actually present an early indication of problems in the future.

In financial accounting, free cash flow (FCF) or free cash flow to firm (FCFF) is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets (known as capital expenditures).[1] It is that portion of cash flow that can be extracted from a company and distributed to creditors and securities holders without causing issues in its operations. As such, it is an indicator of a company's financial flexibility and is of interest to holders of the company's equity, debt, preferred stock and convertible securities, as well as potential lenders and investors.

Free cash flow can be calculated in various ways, depending on audience and available data. A common measure is to take the earnings before interest and taxes, add depreciation and amortization, and then subtract taxes, changes in working capital and capital expenditure. Depending on the audience, a number of refinements and adjustments may also be made to try to eliminate distortions.

There are two differences between net income and free cash flow. The first is the accounting for the purchase of capital goods. Net income deducts depreciation, while the free cash flow measure uses last period's net capital purchases.

The second difference is that the free cash flow measurement makes adjustments for changes in net working capital, where the net income approach does not. Typically, in a growing company with a 30-day collection period for receivables, a 30-day payment period for purchases, and a weekly payroll, it will require more working capital to finance the labor and profit components embedded in the growing receivables balance.

When a company has negative sales growth, it's likely to lower its capital spending. Receivables, provided they are being timely collected, will also ratchet down. All this "deceleration" will show up as additions to free cash flow. However, over the long term, decelerating sales trends will eventually catch up.

where Kt represents the firm's invested capital at the end of period t. Increases in non-cash current assets may, or may not be deducted, depending on whether they are considered to be maintaining the status quo, or to be investments for growth.

Free cash flow can be broken into its expected and unexpected components when evaluating firm performance. This is useful when valuing a firm because there are always unexpected developments in a firm's performance. Being able to factor in unexpected cash flows provides a financial model. [4]

In a 1986 paper in the American Economic Review, Michael Jensen noted that free cash flows allowed firms' managers to finance projects earning low returns which, therefore, might not be funded by the equity or bond markets. Examining the US oil industry, which had earned substantial free cash flows in the 1970s and the early 1980s, he wrote that:

[the] 1984 cash flows of the ten largest oil companies were $48.5 billion, 28 percent of the total cash flows Going to Dominic Anthony Ferrante out of Rancho Cordova of the top 200 firms in Dun's Business Month survey. Consistent with the agency costs of free cash flow, management did not pay out the excess resources to shareholders. Instead, the industry continued to spend heavily on [exploration and development] activity even though average returns were below the cost of capital.

The generic Free Cash Flow (FCF) Formula is equal to Cash from Operations minus Capital Expenditures. FCF represents the amount of cash generated by a business, after accounting for reinvestment in non-current capital assets by the company. This figure is also sometimes compared to Free Cash Flow to Equity or Free Cash Flow to the Firm (see a comparison of cash flow types).

It is possible to derive capital expenditures (CapEx) for a company without the cash flow statement. To do this, we can use the following formula with line items from the balance sheet and income statement.

In practical terms, it would not make sense to calculate FCF all in one formula. Instead, it would usually be done as several separate calculations, as we showed in the first 4 steps of the derivation.

Meanwhile, investors will likely consider investing in companies that have healthy free cash flow profiles, which should ultimately lead to promising futures. Combined with undervalued share prices, equity investors can generally make good investments with companies that have high free cash flow. Investors greatly consider FCF compared to other measures, because it also serves as an important basis for stock pricing and the ability to service debt.

When corporate finance professionals refer to Free Cash Flow, they also may be referring to Unlevered Free Cash Flow, (Free Cash Flow to the Firm), or Levered Free Cash Flow (Free Cash Flow to Equity).

When it comes to valuation and financial modeling, most analysts use unlevered FCF. They will typically create a separate schedule in the model where they break down the calculation into simple steps and combine all components together.

For example, some companies may take longer to pay their debts in order to preserve cash. Alternatively, companies may shorten the time it takes to collect sales made on credit. Companies also have different guidelines on which investments are considered capital expenditures, potentially affecting the computation of FCF.

We hope this has been a helpful guide to understanding the FCF formula, how to derive it, and how to calculate FCF yourself. To keep advancing your career, the additional resources below will be useful:

Gain unlimited access to more than 250 productivity Templates, CFI's full course catalog and accredited Certification Programs, hundreds of resources, expert reviews and support, the chance to work with real-world finance and research tools, and more.

Prior work in finance and economics examining the relation between cash flow and investment expenditure has tended to use either balance sheet measures of the stock of cash and cash equivalents (e.g., Harford, 1999) or earnings based measures as a proxy for cash flow (e.g., Lang, Stulz, & Walkling, 1991; Opler & Titman, 1993). It is well known that earnings and cash flows are not equivalent measures (e.g., Sloan, 1996). This paper seeks to measure free cash flow directly using information from the statement of cash flows as opposed to noisy combinations from the income statement and balance sheet.

Depreciation and amortization is likely to be a reasonable estimate for maintenance investment (of the capital expenditure variety) for firms whose depreciation schedule closely maps with the use of the asset. However, this is not likely to be the case for all firms. Likewise, depreciation and amortization is not likely to be a good approximation of maintenance investment for R&D. Recognizing these limitations, the investment expectation model developed in Section 1.4 includes prior firm level investment. To the extent that there is a temporally constant component to maintenance investment including this variable will help capture such investment.

I estimate the investment expectation model across all firms which implies that the average over-investment across firm-years is equal to zero. Obviously, this analysis is subject to the standard criticism of mis-specification in the investment expectation model (with respect to both functional form and the set of included independent variables). To address these concerns, I consider different sets of independent variables in the investment model (see Section 3) and perform analysis using raw and ranked data as well as a portfolio approach that assumes measurement error is uncorrelated across portfolios (discussed in Section 3.2). My results are robust to all of these specifications.

In the empirical implementation of this model I use a measure of operating earnings. This is driven by practical considerations relating to the predictability of future abnormal earnings. Measures of bottom line earnings do not perform as well as measures of operating earnings in predicting abnormal earnings. This is largely due to the lower persistence of the transitory items that are included in measures of comprehensive or bottom line income (e.g., Dechow et al., 1999).

Specifically, the framework is flexible enough to allow inter-temporal and cross-sectional variation of these last two parameters. However, for my purposes I assume a constant discount rate of 12 percent and the persistence parameter of 0.62 as reported in Dechow et al. (1999). I have re-performed all analyses using (i) industry specific earnings persistence parameters, and (ii) firm specific cost of capital estimates from the CAPM model. The key inference that over-investment is concentrated in firms with positive free cash flow is unaffected by these alternative estimation approaches.

3a8082e126