Free cash flow (FCF) is an important metric to analyze the financial performance of a firm. It is often considered an equally important measure as the net profit of a firm.
There are several ways to calculate the free cash flow of the firm. Similarly, there are various versions of the cash flow that are closely linked. We can consider any of these methods or variants of the FCF.
Let us discuss the concept of FCF, calculation, and its variants.
What is Free Cash Flow?
Free cash flow refers to the cash of a firm after accounting for all cash outflows that can be used for operations and capital expenditures.
Another way to define the FCF is the cash available for a firm that can be freely used for interest payment, dividends, or repayment to creditors.
The calculation adjusts non-cash expenses and includes changes for working capital, operational expenses, and capital expenditures of the firm.
How to Calculate Free Cash Flow?
Free cash flow is the cash left after funding the operational and capital expenditures of a company. It is the net cash flow that is “free” to be used for any use by the company.
Free cash flow can be calculated in different ways. The best possible way to calculate the free cash flow of a company is to look at the line items in the calculation. Calculating each segment of every formula separately makes the job easier. It will also help in better understanding and analysis of the cash flows of the company.
Let us discuss a few key methods used widely to calculate FCF.
Net Income Method
The net income method calculates FCF using the balance sheet and income statement items. It is a popular and commonly used method that is easy to understand as well.
The formula is:
Free Cash Flow = Net Income + Non-Cash Expenses – Increase in Working Capital – Capital Expenditure
Non-Cash Expenses include items that are accounting entries without actual cash flows. Common examples include depreciation, amortization, and impairment charges.
Change in working capital can be calculated by calculating the net of accounts receivable, accounts payable, and net inventory figures.
Change in the capital expenditure can be taken from the cash flow statement directly. Else, the net of PPE (and other capital expenditures) figure from the balance sheet can be adjusted for with the depreciation and amortization.
The simplified version of the formula above can be:
Free Cash Flow = Cash from Operations – Capital Expenditures
Net Operating Profit Method
The FCF can be calculated using the net operating profit or the NOPAT figure as well.
The formula is:
Free Cash Flows = Net Operating Profit After Tax – Net Investment in Operating Capital
We can calculate the net operating profit after tax (NOPAT) and the net investment in operating capital figures separately using the line items from the financial statements.
Net Operating Profit After Tax = Operating Income × (1 – Tax Rate)
Operating Income = Gross Profit – Operating Expenses.
And where Gross Profit = Revenue – Cost of Goods Sold.
Operating expenses include selling, administration, marketing, and other operational expenses.
Investment in operating expenses can also be calculated using the step-by-step approach.
Net investment in operating expenses = Net Operating Capital in Year1 – Net Operating Capital in Year2
Where,
Net operating capital = Net Working Capital + Net PPE
Net Working Capital = Operating Current Assets – Operating Current Liabilities
Operating current assets include cash, accounts receivable, and inventory. Similarly, the operating liabilities figure includes accounts payable and accrual expenses.
Operating Cash Flow Method
The operating cash flow method uses line items from the cash flow statement and the balance sheet. This is a simple and widely used method to calculate and analyze the FCF of a company.
The figures used in this method are readily available in the financial statements of a company.
The formula is given below:
Free Cash Flow = Operating Cash Flow – Capital Expenditure
Although both items used in this formula are available in the cash flow and balance sheet statements, they can also be calculated manually. We can use the same step-by-step approach to calculate these items as described above.
Using Revenue Figure
It is another useful and sensible approach to calculate the free cash flow of a company. This method takes line items from the income statement and the balance sheet of the company.
The formula is:
Free Cash Flow = Sales Revenue – (Operating Costs + Taxes) – Net Investment in Capital Expenditure
The figures of sales revenue and taxes are readily available. Next, we need to deduct operating expenses and tax amounts from the sale figure.
Operating expenses include selling, administration, utilities, and other operational expenses. We can calculate the net investment in capital expenditures using the step-by-step method as discussed above.
In the final step, we can combine all these figures to find the FCF of the company.
Working Example
Let us consider a real-world example to calculate the free cash flow of Amazon Inc. We’ll use the Net Income Method as discussed above for this example.
The available data will be used for FY 2020 from Amazon financial statements.
The formula is:
Free Cash Flow = Net Income + Non-Cash Expenses – Increase in Working Capital – Capital Expenditure
Net income = $ 21,331 (all figures in millions)
Non-Cash Expenses:
| Non-Cash Item | Amount – $ in millions |
| Depreciation + Amortization | 25,251 |
| Deferred Income Tax | (554) |
| Other Operating Income (Loss) | (2,582 + 71) |
| Stock-Based Compensation | 9,208 |
| Total | 31,252 |
Change in Working Capital:
| Non-Cash Item | Amount – $ in millions |
| Accounts Receivable – Net | (2,849) |
| Inventories – Net | (8,169) |
| Accounts Payable – Net | 17,480 |
| Accruals and Other – Net | 7,019 |
| Total | =13,481 |
Change in Capital Expenditure:
| Item | Amount – $ in millions |
| Change in PPE – Net | (35,044) |
| Marketable Securities – Net | (22,242) |
| Other proceeds of sale/purchase– Net | (2,325) |
| Sub-total | (59,611) |
| Net Proceeds of Short-term Debt | 619 |
| Net Proceeds of Long-term Debt | 8,972 |
| Financial Lease and Obligations | (10,695) |
| Other Income/Loss | 618 |
| Total Change in Capital Expenditures | (60,097) |
Now, we can replace all these figures in the formula to find the FCF for Amazon.
Free Cash Flow = 21,331 + 31,252 + 13,481 – 60,097
Free Cash Flow = $ 5,967 million.
Types of Free Cash Flows
There are several variations of free cash flows. Analysts use these measures as and when required. As we have discussed, the methods to calculate the FCF are also various.
Here are a few common versions or different measures of cash flows.
Cash Flow – CF
This is the basic cash flow type. Cash flows from operations can be used as a starting point in analyzing the cash flows of a firm comprehensively.
Net cash from operating activities is the first figure in this calculation. Next, we add depreciation, amortization, and other non-cash expenses. Then, we adjust for any working capital changes net of all effects.
Free Cash Flow – FCF
Unless a firm fulfills its operational and capital expenditure obligations, its cash flow cannot be completely “free”. We can calculate the FCF by adjusting for the capital expenditures in the CF figure.
Once both the operational and capital expenditure commitments are adjusted, the net figure is the free cash flow.
Free Cash Flow to Equity – FCFE
Next, we can differentiate the cash flow available for equity and debt investors separately as well. The measure of FCFE is also termed as the levered cash flow of the firm.
We adjust for the net debt proceeds of the firm in the FCF figure. Net debt proceeds are settlements, payments, or proceeds from both short-term and long-term debts.
The FCFE calculation is useful in evaluating the equity value of a firm.
Free Cash Flow to Firm – FCFF
Free cash flow to the firm is also called unlevered cash flow. It means to find out the cash flows of a company if it had no debt financing.
This method can take a step-by-step approach to find the FCFF figure.
- First, take the earnings before tax or EBT figure.
- Then, calculate the due taxes to the firm without considering any tax shield or special events.
- Deducting the tax amount will give the net profit from the operations figure.
- We can now add depreciation, amortization, and non-cash items to the net operating profit figure.
- Next, we can adjust for changes in net working capital.
- In the last step, we can adjust for the capital expenditures. The resulting figure will be the FCFF.
Interpretation of Free Cash Flow
Generally, higher free cash flows are desirable at any stage and for any business. Higher FCFs means growing sales, increased profits, and increased overall operating efficiency of a business.
Conversely, if a business retains too much cash over the years and accumulates the FCF, it does not offer a positive image either. It means the firm does not have any opportunities to invest in positive NPV projects.
Also, high accumulated FCF means the company isn’t spending on its operational efficiency improvements. Similarly, it may mean the company does not utilize the cash to lower its cost of borrowing.
Similarly, a low or negative FCF figure does not always mean a firm is performing badly. As we have seen, capital expenditure figures play an important part in the calculation of FCF. Thus, a large or one-off capital expenditure can result in a negative FCF.
Thus, the analysis must revolve around trend analysis of the FCFs of the firm. Also, it is wise to evaluate the line items in the formula to figure out the actual causes of cash flow direction.
