Free Cash Flow to Firm Formula

What is the Free Cash Flow to Firm Formula?

After deduction of depreciation, taxes, and working capital, the amount of cash flow from operations available to the firm is known as Free Cash Flow to Firm. It is one of many tools, which are helpful to analyze company finances that measures the profitability of the firm after expenses and investments.

Free Cash Flow to Firm indicates strength in the company’s finances, for analysts while doing business valuation FCFF is useful in Discounted Cash flow analysis, which is used to find out the intrinsic value of the business. It describes the profitability of the business and indication of funds availability with firm even after deductions.

Formula for Free Cash Flow to Firm

Below are the formulas to calculate Free Cash Flow to Firm:

Where,

• NI: Net Income
• D&A: Depreciation and amortization
• I: Interest
• T: Tax Rate

Where,

• CFO: Cash Flow from Operations
• I: Interest
• T: Tax Rate

Where,

• EBIT: Earnings before Interest Tax
• T: Tax Rate
• D&A: Depreciation and Amortisation

While Calculating the Net change in working capital Cash and short term obligations are not considered.

EBITDA: Earnings before Interest Tax Depreciation and Amortisation

Examples to Calculate Free Cash Flow to Firm

Following are details of Company ABC

Income Statement of ABC
(Figures in Millions)	2018	2019
Sales	$1,100	$1,250
Cost of goods sold	$450	$500
Gross profit	$650	$750
Selling, General and Administrative Expenses	$140	$155
EBITDA	$510	$595
Depreciation	$135	$175
EBIT	$375	$420
Interest expense	$45	$60
Pre-tax earnings	$330	$360
Taxes (30%)	$99	$108
Net Income	$231	$252

 

Balance Sheet of ABC
(Figures in Millions)
Assets	2018	2019
Cash	$40	$60
Accounts receivable	$70	$110
Inventory	$120	$145
Current assets	$230	$315
Fixed Assets	$1,400	$1,600
Accumulated depreciation	$460	$500
Total Assets	$1,170	$1,415
Liabilities	2018	2019
Accounts payable	$75	$95
Short-term debt	$60	$80
Current liabilities	$135	$175
Long term debt	$600	$650
Common stock	$200	$200
Retained earnings	$235	$390
Total liabilities and Equity	$1,170	$1,415

Now to Calculate Free Cash Flow to Firm we need,

EBIT = $420

EBITDA = $595

Net Income = $252

Depreciation and Amortisation = $175

Capital Expenditure = Fixed asset 2019 – Fixed asset 2018 = $200(Cash Outflow)

Net Change in Working Capital	2018	2019	Change
Current Asset
Accounts receivable	$         70	$       110	$     -40
Inventory	$       120	$       145	$     -25
Current Liabilities
Accounts payable	$         75	$         95	$      20
Working Capital (Current Assets – Current Liabilities)	$       115	$       160	$     -45

Net Change in Working Capital = – $45(Cash Outflow)

Net Income Approach

FCFF = NI + D&A + (I * (1 – T)) – Capital Expenditure + Changes in Net Working Capital

• FCFF = $252 + $175 + ($60 * (1 – 30%)) – $200 – $45
• FCFF = $224 (mn)

EBIT Approach

FCFF = (EBIT * (1 – T)) + D&A – Capital Expenditure + Changes in Net Working Capital

• FCFF = ($420 * (1 – 30%)) + $175 – $200 – $45
• FCFF = $224 (mn)

FCFF = (EBITDA * (1 – T)) + (D&A * T) – Capital Expenditure + Changes in Net Working Capital

• FCFF = ($595 * (1 – 30%)) + ($175 * 30%) – $200 – $45
• FCFF = $224 (mn)

Evaluation Using FCFF

Free Cash Flow to Firm indicates cash, which is available with the company for investors after payment of all debts, expenses, investment in current asset,s and investment in long-term assets. FCFF indicates the company’s growth and performance over the years. It is one of the most important tools in the calculation valuation of the stock. For investors, it is helpful to understand while investing whether such stocks are overvalued or undervalued in terms of price.

Positive Value of FCFF indicates a company is able to maintain cash even after expenses and investments, Negative value of FCFF indicates the company’s inability to generate enough revenue to match its operating costs and investment activities. Although negative FCFF can be a result of the company’s increase in investment for future growth, an investor should understand and study a company’s finances before making a judgment.

Importance and Uses of Free Cash Flow to Firm

• Difficult to Manipulate: Compare to other indicators like EPS(Earning per share) Free Cash Flow to Firm tells a much accurate picture, as Earnings can be manipulated with aggressive accounting practices like a high rate of depreciation. But in FCFF considering actual cash flows, this method is much helpful in analysis.
• Indicators for Business: Business with positive FCFF indicates the sound financial health of the company while negative FCFF indicates the company’s inability to generate higher revenues. FCFF also tells about the performance of business and investments.
• Indicator for Investor: Free Cash Flow to Firm indicates indicate company’s performance and ability to manage its operations without shortage in cash, which also means the company can pay dividends, reinvest money in capital asset targeting growth and eventually helpful in the growth of a business that will provide capital appreciation to investors. For an investor, FCFF can be quite helpful in understanding the company’s financial scenario.

FCFF vs FCFE

	Free Cash Flow to Firm	Free Cash Flow to Equity
Definition	Cash flow is available to the firm and all investors after the deduction of expenses, tax, reinvestment, and debt payments.	Free Cash Flow to Equity indicates how much cash left with the firm for equity shareholders after deductions of expenses, reinvestment, and debt payments.
Leverage	It is unlevered cash flow as it does not consider the effects of leverage.	FCFE is levered cash flow as it considers the effects of leverage by deducting interest payments to arrive at final calculations of cash flow
Usage	FCFF is used in the calculation of business valuations	FCFE is used in the Valuation of Equity holders.
Calculation	IN DCF model Weighted average cost of capital is used in the calculation of the capital structure	Cost of Equity is used in a calculation to understand free cash flow for equity
	All investors and management prefer FCFF as in case of high leverage it helps in maintaining a better picture.	Equity Investors and Analysts prefer FCFE as It provides a much accurate picture of business in case of high leverage.

Conclusion

Free Cash Flow to Firm is the cash-generating ability of the firm even after the deduction of expenses, taxes, and income, indicating the firm’s financial health and growth prospects. Compare to EPS FCFF is much helpful as it can be difficult to manipulate as it only considers transactions involving actual cash outflow and inflow in business. Positive FCFF indicates the company’s ability to grow without external funding.

For investors looking for capital growth and income, FCFF can be helpful as companies with positive FCFF value either reinvest in capital assets targeting further growth or give dividends to shareholders.

Although Negative value in FCFF is considered as bad an investor needs to dig deep and understand the company’s finances before making any judgment. The investor can perform an analysis of multiple years to understand whether a company is showing growth or is under stress.

Recommended Articles

This is a guide to Free Cash Flow to Firm. Here we discuss the formulas, examples to calculate Free Cash Flow to Firm, importance, and uses. You can also go through our other related articles to learn more –

1. Absolute Value Formula
2. Turnover Ratio Formula
3. Types of Financial Model
4. FCFF Formula