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What is Free Cash Flow to the Firm?
Free Cash Flow to the Firm (FCFF) represents any cash remaining after deducting a company’s depreciation, taxes, working capital, and other investment costs from its revenues. This amount shows any cash flow available for companies to distribute to their financiers, whether debtholders, stockholders, preferred stockholders, or bondholders.
Free Cash Flow to the Firm also represents any surplus cash flows available to companies assuming they were debt-free. Therefore, another name for the FCFF is unlevered free cash flow. FCFF can help investors gauge a company’s profitability after deducting all expenses and reinvestments. For most companies, the FCFF may also be an indicator of financial health.
How to calculate the Free Cash Flow to the Firm?
There are several ways in which investors can calculate a company’s Free Cash Flow to the Firm. These are as below.
Free Cash Flow to the Firm = [EBIT x (1 – Tax Rate)] + Non-Cash Expenses + Changes in Working Capital – Capital Expenditure
The [EBIT x (1 – Tax Rate)] part is also known as a company’s Net Operating Profits After Taxes (NOPAT). The non-cash expenses part usually includes depreciation. Similarly, changes in working capital represent any investments that a company has made in its working capital. Lastly, capital expenditure includes all long-term investments that companies make.
Another formula that investors can use to calculate the Free Cash Flow to the Firm is as follows.
Free Cash Flow to the Firm = Net Income + Non-Cash Expenses + [Interest x (1 – Tax Rate)] – Capital Expenditure – Changes in Working Capital
This formula uses a company’s Net Income instead of the NOPAT. The rest of the formula is similar to the one before.
The next approach to calculating the Free Cash Flow to the Firm is as below.
Free Cash Flow to the Firm = Cash flow from operations + [Interest x (1 – Tax Rate)] – Capital expenditures
Lastly, investors can also use the formula below to calculate the Free Cash Flow to the Firm.
Free Cash Flow to the Firm = [EBITDA x (1 – Tax Rate)] + (Depreciation x Tax Rate) – Capital Expenditure – Changes in Working Capital
EBITDA is a company’s Earnings Before Interest, Taxes, Depreciation, and Amortization.
What is the importance of Free Cash Flow to the Firm?
Free Cash Flow to the Firm is a metric that is important for several reasons. Firstly, it presents investors with an alternative to the Earnings Per Share, which uses profits. These profits are easily manipulatable, making it difficult for investors to trust them. FCFF is also crucial for dividend-seeking investors. It is because it is a reliable measure of a company’s ability to maintain dividend payments.
Free Cash Flow to the Firm is also a great indicator of a company’s cash flow position. Companies that have consistently high FCFFs are likely to have a better cash management process. Similarly, FCFF is also useful for identifying growth-oriented stocks. High FCCFs mean that companies are likely to use their free cash for further investments. These can result in higher profits in the future.
Conclusion
Free Cash Flow to the Firm is a metric that investors can use to calculate a company’s free cash flows. These come after deducting the company’s depreciation, taxes, working capital, and other investment costs. Investors can use various formulas to calculate the FCFF.
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