Free Cash Flow
Free cash flow (FCF) represents the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.Interest payments are excluded from the generally accepted definition of free cash flow.Investment bankers and analysts who need to evaluate a company’s expected performance with different capital structures will use variations of free cash flow like free cash flow for the firm and free cash flow to equity, which are adjusted for interest payments and borrowings.
Free Cash Flow (FCF)
Definition
Free Cash Flow (FCF) refers to the cash generated by a company after accounting for cash outflows to support operations and maintain capital assets. Unlike profit or net income, FCF is a measure of profitability that excludes non-cash expenses from the income statement and includes capital expenditures and changes in working capital from the balance sheet. Interest payments are not included in the commonly accepted definition of FCF.
Origin
The concept of Free Cash Flow originated in the mid-20th century and has become an important metric for assessing a company's financial health as corporate financial management and investment analysis have evolved. Particularly in the 1980s, with the maturation of capital markets and increased investor focus on cash flow management, the application of FCF became more widespread.
Categories and Characteristics
Free Cash Flow can be categorized into the following types:
- Unlevered Free Cash Flow (UFCF): Cash flow that does not consider interest payments and borrowings, typically used to assess the overall operational efficiency and profitability of a business.
- Levered Free Cash Flow (LFCF): Cash flow that considers interest payments and borrowings, typically used to assess the actual returns to shareholders.
The main characteristics of Free Cash Flow include:
- Exclusion of non-cash expenses: Such as depreciation and amortization, making cash flow more reflective of actual cash movements.
- Inclusion of capital expenditures: Such as purchases of equipment and assets, reflecting the company's investments in maintaining and expanding its business.
- Consideration of changes in working capital: Such as changes in accounts receivable and accounts payable, reflecting the company's day-to-day operational funding needs.
Specific Cases
Case 1: Suppose Company A has a net income of 10 million yuan in a fiscal year, depreciation and amortization expenses of 2 million yuan, capital expenditures of 3 million yuan, and an increase in working capital of 1 million yuan. The calculation of the company's Free Cash Flow is as follows:
Free Cash Flow = Net Income + Depreciation and Amortization - Capital Expenditures - Changes in Working Capital = 10,000,000 + 2,000,000 - 3,000,000 - 1,000,000 = 8,000,000 yuan.
Case 2: Company B has a net income of 5 million yuan in a quarter, depreciation and amortization expenses of 500,000 yuan, capital expenditures of 1 million yuan, and a decrease in working capital of 200,000 yuan. The calculation of the company's Free Cash Flow is as follows:
Free Cash Flow = Net Income + Depreciation and Amortization - Capital Expenditures - Changes in Working Capital = 5,000,000 + 500,000 - 1,000,000 + 200,000 = 4,700,000 yuan.
Common Questions
1. How is Free Cash Flow different from net income?
Free Cash Flow excludes non-cash expenses and includes capital expenditures and changes in working capital, whereas net income only reflects income and expenses on the income statement.
2. Why does Free Cash Flow not include interest payments?
Free Cash Flow is typically used to assess a company's operational efficiency and profitability without considering the impact of capital structure, hence it does not include interest payments.
