The cash a company generates after accounting for financial outflows to sustain operations and maintain capital assets is referred to as free cash flow (FCF). FCF, in simple terms, is the money left over after paying for items like payroll and taxes, which a firm can utilise anyway it sees fit.
The ability of a company to create profit is important for creating a positive image in front of investors and creditors. They consider a company’s free cash flow situation when assessing a business’s viability and growth prospects.
1. Free Cash Flow To The Firm (FCFF)
It reflects a company’s ability to generate cash after accounting for its capital expenditures. Typically, the cash flow generated from operations is used to calculate FCFF. Alternatively, the net income of a company can be used to calculate the same.
FCFF = Cash Flow Generating From Operating Activities – Capital Expenditure
2. Free Cash Flow To Equity (FCFE)
It is also known as leveraged cash flow because it is the cash flow made available to the company’s equity shareholders. It is the amount of money that a company can release as dividends to its equity owners. Firms can also use the funds for stock buybacks once all expenses and debts have been paid and reinvestments have been taken into account.
FCFE = FCFF + Net borrowing – Interest amount * (1-tax)
Calculate Free Cash Flow
By excluding non-cash items from the income statement, FCF can be used to determine a company’s profitability.
It also takes into account equipment expenses and changes in working capital. Interest payments, for example, are not included in free cash flow.
There are alternatives to the free cash flow formula using comparable formulae that compute the same information if a corporation does not mention capital expenditures and operating cash flow.
FCF = Operating Cash – Capital Expenditure