Definition
In corporate finance, free cash flow or free cash flow to firm is a way of looking at a business’s cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, and convertible security holders when they want to see how much cash can be extracted from a company without causing issues to its operations.
Free Cash Flow
Free cash flow (FCF) is a financial technique that investors use when evaluating an investment’s financial performance. The metric is used to find out the net value of the company. This information is used by investors in making financial decisions. It allows investors to know whether the company has generated enough revenue that covers expenditure incurred to maintain or expand the assets.
How Free Cash Flow is Calculated?
FCF is calculated simply by subtracting capital expenditures from operating cash flow. Another formula to calculate FCF is given below.
EBIT (1-tax rate) + Amortization and Depreciation – Capital expenditure – Change in Working Capital
where,
EBIT = Earnings before Income and Tax
Suppose a company’s earnings in a particular quarter is $500,000, the tax rate is 35%, amortization and depreciation is $5,000, capital expenditure is $400,000, and that the working capital has increased by $50,000. Then, after the values are put in the equation above, FCF of the company equals -$120,000. Even though the earnings of the company was positive, the FCF of the company turned out to be negative.
Importance of FCF for Investors
Investors can use FCF metric to make informed financial decisions and to know whether the company is operating in the green. A positive cash flow indicates that the company will be able to meet its financial obligations without resorting to additional debt. A negative cash flow on the other hand indicates that the company is not making enough revenues to maintain the business.
Note that negative cash flow does not mean that a company is a bad buy. It may be that the company is at the expansion stage and making investments that will improve its profits in the future. Most startups have negative cash flow as they invest heavily to expand their operations.
That being said, an FCF that remains negative for a long time should raise a red flag. A company that is unable to generate enough income to cover expenses will not be able to continue its operations if the situation persists for a long time. The metric should be best used with other financial metrics such as P/E ratio, working capital ratio, profit margin and others to determine the real financial position of the company.
Further Reading
- Agency costs of free cash flow, corporate finance, and takeovers – www.jstor.org [PDF]
- The free cash flow theory of takeovers: A financial perspective on mergers and acquisitions and the economy – papers.ssrn.com [PDF]
- Dividend announcements: Cash flow signalling vs. free cash flow hypothesis? – www.sciencedirect.com [PDF]
- Over-investment of free cash flow – link.springer.com [PDF]
- Institutional Environment and Overinvestment of Free cash flow [J] – en.cnki.com.cn [PDF]
- The valuation of corporate R&D expenditures: Evidence from investment opportunities and free cash flow – www.jstor.org [PDF]
- Determinants of corporate restructuring: The relative importance of corporate governance, takeover threat, and free cash flow – onlinelibrary.wiley.com [PDF]
- The impact of free cash flow, financial leverage and accounting regulation on earnings management in Australia's “old” and “new” economies – www.emerald.com [PDF]
- Market response to product-strategy and capital-expenditure announcements in Singapore: Investment opportunities and free cash flow – www.jstor.org [PDF]
- Ownership structure, cash flow, and capital investment: Evidence from East Asian economies before the financial crisis – www.sciencedirect.com [PDF]
