Free Cash Flow [FCF] is one of the indicators most frequently monitored by business people, banks, investors and other analysts. It is important because it measures the financial performance of a business.
But what exactly is Free Cash Flow? What purpose does it serve? How is it calculated? And, above all, what does it mean? Read on for all the answers to these questions, and many more.
Free Cash Flow [FCF] Defined
Free Cash Flow [FCF] corresponds to the amount of money the business generates through its day-to-day operations, and which is truly available after the investments necessary to maintain or develop production have been paid [maintenance, fixed costs, asset development, etc.].
Free Cash Flow is a capital that can be reinvested in the business, or used to pay the company’s different capital providers. Interest can be paid to creditors, the company's debt can be reduced, and shareholders may redeem shares or receive dividends.
Free Cash Flow is one of the Cash Flows you can calculate with your cash flow statement.
Free Cash Flow Explained
Free Cash Flow actually means available cash flow.
Practical Example of Free Cash Flow
To explain the principle of Free Cash Flow [FCF] in practical terms, let’s take the example of a plumbing business.
The company's cash flow will come from its regular income: i.e. services provided and products sold [repairs, equipment, advice, etc.].
At the end of the month, the company manager will use this cash to:
- pay the staff;
- buy equipment sold or used;
- replace damaged tools;
- maintain premises and service company vehicles [painting, repairs, etc.];
- and obviously pay their own salary.
Once all these payments made, if any money from the past month’s income is left over, it will be what we call Free Cash Flow.
Our plumbing firm can use this capital in different ways:
Invest in the growth of the business, for example by buying out a competitor or purchasing new premises;
Repay a part of the firm’s debts, so that it is less dependent on banks and other creditors, and is owned more by its shareholders [here, the owner of the business];
Pay some or all of this capital to shareholders, as dividends.
What is the purpose of Free Cash Flow [FCF]?
Calculating the Free Cash Flow of your business gives you a real idea of its financial performance and its potential for action. Seizing an investment opportunity can end in disaster if you don’t have an exact picture of its cash position.
This is why Free Cash Flow is an indicator that decision-makers, creditors, investors and business analysts look at so often. Without cash, it will be difficult for the company to develop new offerings, acquire new assets, pay dividends or reduce its debt.
Free Cash Flow is a very precise tool for measuring the financial soundness of a business. If it is properly interpreted, it provides valuable information about the current position and helps make decisions for the future accordingly.
Free Cash Flow [FCF]: A more precise indicator than the Balance Sheet
Free Cash Flow and Balance Sheet: What’s the difference?
Free Cash Flow therefore lets you know whether a company generates a positive cash flow: in short, whether it generates value. Obviously, there are a number of tools that can provide this information, starting with the balance sheet. At the end of the accounting year, you simply need to check whether the company’s net result is a profit, to come to the same conclusion as with the FCF.
Example of a Balance Sheet
But this is not quite true, because the balance sheet and Free Cash Flow do not concern exactly the same data. Balance sheets include both monetary entries [sales, purchases, salaries] and non-monetary items [allowances, depreciation, changes in inventory, etc.].
A more precise indicator than the Balance Sheet
So, the balance sheet entries do not really reflect the money available to the business. The result of the year, for instance, is calculated according to a multitude of accounting standards. And they will often not exactly reflect the money actually generated over a given period.
For instance, when a firm invests, in property for example, this expenditure is spread over the entire duration of the investment. A purchase of $100,000, with an estimated depreciation period of 10 years will mean that the book result only comes down by $10,000 each year for ten years.
Conversely, when a business makes a sale, the entire amount is entered in the accounting results, even if the payment is not yet effective, or payment facilities are granted by suppliers.
All these standards and different periods can make it complicated to calculate the income actually generated using a traditional balance sheet. And this is where Free Cash Flow comes in, with its ability to do the calculation more concretely.
Calculating Free Cash Flow [FCF]
There are several ways to calculate Free Cash Flow, using your balance sheet or your cash flow statement.
In France, the Financial Markets Authority [AMF] encourages groups to use non-standard indicators in their financial disclosures, such as Free Cash Flow, EBITDA, etc., provided that they explain how they are calculated.
Free Cash Flow Calculation via the Cash Flow Statement
If you have a cash flow statement, you can easily obtain your Free Cash Flow data. Here is the basic formula for calculating the Free Cash Flow of a business:
Free Cash Flow [FCF] = Cash Flow from Operating Activities – Cash Flow from Investing Activities
The components are:
Cash Flow from Operating Activities. This is the money coming into and going out of the company for its everyday business: purchases of raw materials or goods, paying wages and sales of finished products, etc.
Cash Flow from Investing Activities. This means all the flows of capital designed to maintain and grow production: buying new machinery or new sites for example.
Corporate Tax.
Free Cash Flow Calculation via the Balance Sheet Items
In this case, you can calculate the FCF in different ways:
Free Cash Flow [FCF] = GOS + disposals of assets – investments +/- Change in WC – tax on profits
Or
Free Cash Flow [FCF] = Gross Operating Surplus [GOS] – Tax on profits – Change in working capital requirement [∆ WCR] + Disposals of Fixed Assets – Investments
Companies use different variations on the FCF calculation:
The self-financing capacity can be used instead of the formula based on Gross Operating Surplus – Corporate Tax. This indicator more specifically measures the cash surplus generated by operations excluding financial expenses;
Some groups exclude intra-group trade receivables and payables to calculate the change in WCR as they are eliminated in the consolidated result, the Free Cash Flow being used to assess financing needs at group level;
Some groups actually only integrate recurring maintenance investments into cash flow from investing activities, which is generally of a small amount. So Free Cash Flow is supposed to always be positive.
Free Cash Flow to Firm and Free Cash Flow to Equity
A distinction must be drawn between two concepts stemming from Free Cash Flow: Free Cash Flow to Firm, which corresponds to the amount available to all the investors, including holders of debt, and Free Cash Flow to Equity, which concerns the Free Cash Flow available solely to shareholders.
Free Cash Flow to Firm [FCFF]
FCFF corresponds to the amount of money available to investors, including holders of debt. The amount of available interest is the amount after tax. In practice, the interest expense must be added to the Free Cash Flow.
FCFF is particularly used to value companies because it provides a good estimate of available cash flows before any leverage effect generated by the company’s financing structure.
It can be calculated in several ways:
** Method 1:** Cash flows from operations + Interest x [1-tax rate] – Capital investments
** Method 2:** Net Profit + Depreciation + Other non-monetary interest + Interest x [1-tax rate] - Capital investments - Investments in working capital.
Free Cash Flow to Equity [FCFE]
For its part, FCFE only remunerates equity contributors: i.e. the shareholders. It also has the particular feature of being net of tax and calculated after deduction of debt servicing and coverage of investment needs and changes in Working Capital Requirement [WCR].
Analysing Free Cash Flow [FCF]
Analysing Free Cash Flow is essential, as it allows you to monitor changes in a company’s financing needs. Within a group, for example, the CFO might consolidate the FCF forecasts of all the entities to find out whether the group will generate or use up cash the following year.
A company’s FCF can be positive or negative over a given period. If the Free Cash Flow is negative, the company’s debt will grow in theory. If it is positive, the company will be able to reduce it.
Positive Free Cash Flow
If the Free Cash Flow generated by the company is positive, this shows that it is capable of generating a cash surplus once it has paid its investment and operating expenses.
Over several accounting years, the year in which the aggregate FCF becomes positive is the return on investment period. This is why a positive FCF, which does not increase the debt and is nearing the ROI point, will be particularly reassuring for an investor.
Negative Free Cash Flow
Despite the connotations of “negative”, a negative FCF is not necessarily as bad thing. Since the FCF is calculated by taking into account the investments made by the company, a negative Free Cash Flow might only be due to substantial investments. These investments, which result in a negative FCF in one year, may be stopped the following year, or even result in a substantial return on investment [ROI]: and all these factors will lead to a positive Free Cash Flow.
That’s why it is vital to track and analyse Free Cash Flow over relatively long periods: because you can only assess the company’s real capacity to make money over long periods.
Change in Free Cash Flow [FCF]
Cumulative Free Cash Flow, a very important indicator
As we have already seen: FCF changes over time, and that’s why it is a pertinent metric. When a business first starts up, the Free Cash Flow may be negative as a result of investments, creation of Working Capital [WC], or possibly start-up losses.
As the time at which cumulative FCF becomes positive marks the start of the return on investment, it is vital to anticipate and manage this aspect as much as possible. If the period before generating a return on investment is long, an investor whose assets have a short lifespan will think he has made a bad investment.
Maintaining Free Cash Flow
A business can look for ways to maintain its Free Cash Flow. If the economic performances are disappointing, managing expenditures will be the main action lever.
Naturally, reducing or deferring expenditures can be a wise decision in a difficult year. The company’s finance department must then work with operations to find the right balance: Can investments, recruitments, and other expenditures initially planned be called into question without affecting the operational performance?
In a nutshell
Free Cash Flow is a key indicator of a business’s performance, and must be carefully monitored and analysed. Over time, it is one of the first indications of a return on investment, and by interpreting it correctly, investors, decision-makers and analysts are able to make coherent projections for the company's future, and take decisions accordingly.
Do you know all about cash management? Need a refresher on cash management ? Discover Cash Academy, a course totally free of charge!