FCFF or Free Cash Flow to Firm, is one of the most important concepts in Equity ResearchEquity ResearchEquity Research refers to the study of a business, i.e., analyzing a company’s financials, performing Ratio Analysis, Financial forecasting in Excel (Financial Modeling), & exploring scenarios to make insightful BUY/HOLD/SELL stock investment recommendations. Moreover, the Equity Research Analysts discuss their findings & details in the Equity Research Reports. read more and Investment Banking firms.

Warren Buffet (1992 annual report) said, “The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.”

Warren Buffet has been focusing on a company’s ability to generate Free Cash Flow to Firm. Why does this really matter? This article will focus on understanding what “Free Cash Flows” are in general and why FCFF should be used to measure a company’s operating performance.

This article is structured as per below – 

Here we discuss FCFF, however, if you want to know more about FCFE, you can look at Free Cash Flow to EquityFree Cash Flow To EquityFCFE (Free Cash Flow to Equity) determines the remaining cash with the company’s investors or equity shareholders after extending funds for debt repayment, interest payment and reinvestment. It is an indicator of the company’s equity capital managementread more.

#1 – What is Free Cash Flow to Firm or FCFF

In order to gain an intuitive understand of Free Cash Flow to Firm (FCFF), let us assume that there is a guy named Peter who started his business with some initial equity capital (let us assume $500,000), and we also assume that he takes a bank loan of another $500,000 so that his overall finance capital stands at $1000,000 ($1 million).

  • The business will begin earning revenues, and there would be some associated expenses.As for all the businesses, Peter’s business also requires constant maintenance capital expenditure in assets each year.Debt Capital Raised in year 0 is $500,000Equity CapitalEquity CapitalEquity Capital refers to the capital collected by a company from its owners and other shareholders in exchange for a portion of ownership in the company.read more raised in year 0 is $500,000There is no cash flow from operationsCash Flow From OperationsCash flow from Operations is the first of the three parts of the cash flow statement that shows the cash inflows and outflows from core operating business in an accounting year. Operating Activities includes cash received from Sales, cash expenses paid for direct costs as well as payment is done for funding working capital.read more and cash flow from investmentsCash Flow From InvestmentsCash flow from investing activities refer to the money acquired or spent on the purchase or disposal of the fixed assets (both tangible and intangible) for the business purpose. For instance, the purchase of land and joint venture investment is cash outflow, while equipment sale is a cash inflow.read more as the business is yet to start.

FCFF – Free Cash Flow  Video

Scene # 1 – Peter’s Business with not enough earnings

  • We assume that the business has just started and generates a modest $50,000 in year 1Cash flow from Investments in Assets is higher at $800,000Net CashNet CashNet Cash represent the company’s liquidity position and is calculated by deducting the current liabilities from the cash balance reported on the company’s financial statements at the end of a particular period. Analysts and investors examine it to have a better understanding of the company’s financial and liquidity position.read more position at the end of the year is $250,000

  • Let us now assume that Peter’s business generated only $100,000 in Year 2In addition, in order to maintain and run the business, he needs to regularly invest in assets (maintenance Capex) of $600,000What do you think will happen in such a situation? Do you think the Cash at the beginning of the year is sufficient?- NO.Peter will need to raise another set of capital – this time, let us assume he raises another $250,000 from the bank.

  • Now let us analyze a stressed situation for Peter :-). Assuming that his business is not doing well as expected and was able to generate only $100,000Also, as discussed earlier, maintenance capital expenditure cannot be avoided; Peter must spend another $600,000 to keep the assets running.Peter will require another set of external funding to the tune of $500,000 to keep the operations running.Debt financing of another $250,000 at a relatively higher rate and Peter invests another $250,000 as equity capital.

  • Again in year 4, Peter’s business was able to generate only $100,000 as cash flows from operations.Maintenance capital expenditure (unavoidable) is at $600,000Peter requires another set of funding of $500,000. This time, let us assume that he doesn’t have any amount as equity capital. He again approaches the bank for another $500,000. However, this time the bank agrees to give him a loan at a very high rate (given the business is not in good shape and his earnings are uncertain)

  • Yet again, Peter was only able to generate $100,000 as cash flows from core operationsCapital expenditure that is unavoidable still stands at $600,000This time the Bank declines to give any further loan!Peter is unable to carry forward the business for another year and files for bankruptcy!After filing for bankruptcy, Peters business assets are liquidated (sold) at $1,500,000

Bank has given a total loan of $1500,000. Since Bank has the first right to recover their loan amount, the amount received on liquidation will be first used to serve the Bank, and Peter will receive the remaining excess amount (if any). In this case, Bank was able to recover their invested amount as the liquidation valueLiquidation ValueLiquidation value is the value of assets that remain if the company goes out of business and is no more a going concern. Liquidation value is calculated only for tangible assets such as real estate, machinery, equipment, investment etc.read more of Peter’s Asset is at $1,500,000

Peter has invested his own capital (equity) of $750,000. In this case, Peter receives no money as all the liquidated amount goes to the serving of the bank. Please note the return to the shareholder (Peter) is zero.

Scene # 2 – Peter’s Business Grows and show’s recurring earnings

Let us now take another case study where Peter’s business is not doing badly and growing each year.

  • Peter’s business steadily grows from CFO of $50,000 in year 1 to CFO of 1,500,000Peter raises only $50,000 in year two due to liquidity requirements.After that, he does not need any other set of cash flow from financing to “survive” the future yearsEnding cash for Peter’s Company grows to $1350,000 at the end of year 5We see that excess cash is positive (CFO + CFI) from year three and is growing every year.

Bank has given a total loan of $550,000. In this case, Peter’s business is doing well and generating positive cash flows; he can pay off the bank loan and interest within the mutually agreed time frame.

Peter has invested his capital (equity) of $500,000. Peter has 100% ownership in the firm, and his equity return will now depend on the valuation of this business that generates positive cash flows.

# 2 – Layman’s Definition of Free Cash Flow to Firm (FCFF)

To appreciate the layman’s definition of Free Cash Flow to the firm or FCFF, we must make a quick comparison of Case Study 1 and Case Study 2 (discussed above) 

  • If excess cash (CFO + CFI) is positive and growing, the company has valueIf Excess Cash (CFO + CFI) is negative for an extended period of time, then the return to the shareholder may be very low or closer to zero

“Excess Cash” is nothing but Free Cash Flow to Firm or FCFF calculation. DCF valuation focuses on the cash flows generated by the Operating Assets of the business and how it maintains those assets (CFI). 

FCFF formula = Cashflows from operations (CFO) + Cashflows from Investments (CFI)

#3 – Free Cash Flow – Analyst’s Formula 

 Free Cash Flow to firm formula can be represented in the following Three way –

Free Cash Flow to Firm or FCFF Calculation = EBIT x (1-tax rate) + Non Cash Charges + Changes in Working capital – Capital Expenditure

Net Income + Depreciation & amortization + Interest x (1-tax) + changes in Working Capital – Capital Expenditure

EBITDA x (1-tax rate) + (Dep & Amortization) x tax rate + changes in Working Capital – Capital Expenditure

I will leave it to you to reconcile one formula with the other one. Primarily you can use any of the given FCFF formulas. As an Equity analyst, I found it easier to use the formula that started with EBIT.

 Additional notes on FCFF Formula Items

  • Net income is taken directly from the Income statement.It represents the income available to shareholders after taxes, depreciationDepreciationDepreciation is a systematic allocation method used to account for the costs of any physical or tangible asset throughout its useful life. Its value indicates how much of an asset’s worth has been utilized. Depreciation enables companies to generate revenue from their assets while only charging a fraction of the cost of the asset in use each year.

  • read more, amortization, interest expenses, and the payment to preferred dividends.

  • Non-cash charges are items that affect net income but do not involve cash payment. Some of the common non-cash items are listed below.

  • Since interest is tax-deductible, after-tax interest is added to the net incomeInterest cost is cash flow to one of the firm’s stakeholders (debt holders), and hence, it forms a part of FCFF.

  • Investment in fixed assets is the cash outflow required for the company to maintain and grow its operations.A company may acquire assets without expending cash by using stock or debt.The analyst should review the footnotes, as these asset acquisitions may not have used cash and cash equivalentsCash And Cash EquivalentsCash and Cash Equivalents are assets that are short-term and highly liquid investments that can be readily converted into cash and have a low risk of price fluctuation.  Cash and paper money, US Treasury bills, undeposited receipts, and Money Market funds are its examples. They are normally found as a line item on the top of the balance sheet asset. read more in the past, but may affect the forecast of future Free Cash Flow to Firm

  • The working capital changes that affect FCFF are items such as Inventories, Accounts Receivables, and Accounts PayableAccounts Receivables, And Accounts PayableWhile Accounts Receivable is the capital amount that the clients/customers owe to the business, Accounts Payable is the capital amount that the business owes to its suppliers. read more.This definition of working capital excludes cash and cash equivalents and short-term debt (notes payable and the current portion of long term debtCurrent Portion Of Long Term DebtCurrent Portion of Long-Term Debt (CPLTD) is payable within the next year from the date of the balance sheet, and are separated from the long-term debt as they are to be paid within next year using the company’s cash flows or by utilizing its current assets.read more payable).Do not include non-operating current assetsCurrent AssetsCurrent assets refer to those short-term assets which can be efficiently utilized for business operations, sold for immediate cash or liquidated within a year. It comprises inventory, cash, cash equivalents, marketable securities, accounts receivable, etc.read more and liabilities, e.g., dividends payableDividends PayableDividend payable is that portion of accumulated profits that is declared to be paid as dividend by the company’s board of directors. Until the dividend declared is paid to the concerned shareholders, the amount is recorded as a dividend payable in the head current liability.read more, etc.

4 – FCFF Example in Excel

With the above understanding of the formula, let us now look at the firm’s working example of calculating Free Cash Flows. Let us assume that you have been provided the Balance SheetThe Balance SheetA balance sheet is one of the financial statements of a company that presents the shareholders’ equity, liabilities, and assets of the company at a specific point in time. It is based on the accounting equation that states that the sum of the total liabilities and the owner’s capital equals the total assets of the company.read more and Income Statement for a company as provided below. You can download the FCFF Excel Example here

Calculate FCFF (Free Cash Flow to Firm) for the year of 2008

Let us try to solve this problem using the EBIT approach.

FCFF Formula =  EBIT x (1-tax) + Dep & Amort + Changes in Working Capital – Capital Expenditure

EBIT = 285, tax rate is 30%

EBIT x (1-tax) = 285 x (1-0.3) = 199.5

Depreciation  = 150

Capital Expenditure = change in Gross Property Plant and EquipmentProperty Plant And EquipmentProperty plant and equipment (PP&E) refers to the fixed tangible assets used in business operations by the company for an extended period or many years. Such non-current assets are not purchased frequently, neither these are readily convertible into cash. read more (Gross PPE) = $1200 – $900 = $300

FCFF calculation = 199.5 + 150 – 75 – 300 = -25.5

Calculating Free Cash Flow for a Firm is fairly straightforward. Why don’t you calculate FCFF using the other two FCFF formulas – 1) Starting with Net Income, 2) Starting with EBITDAEBITDAEBITDA refers to earnings of the business before deducting interest expense, tax expense, depreciation and amortization expenses, and is used to see the actual business earnings and performance-based only from the core operations of the business, as well as to compare the business’s performance with that of its competitors.read more

#5 – Alibaba FCFF – Positive and Increasing FCFF 

For Alibaba DCF, I had made the financial statement analysis, forecast financial statements and then calculate Free Cash Flow to the Firm. You can download Alibaba Financial Model here.

Presented below is the Free Cash Flow to the Firm of Alibaba. The Free Cash flow is divided into a) Historical FCFF and b) Forecast FCFF.

  • Historical Free Cash Flow to Firm is arrived at from the Income Statement, Balance Sheet, and Cash Flows of the company from its Annual ReportsIts Annual ReportsAn annual report is a document that a corporation publishes for its internal and external stakeholders to describe the company’s performance, financial information, and disclosures related to its operations. Over time, these reports have become legal and regulatory requirements.read more.Forecast Free Cash Flow to Firm calculation is done only after forecasting the Financial Statements (we call this as preparing the financial model in excel). Financial Modeling fundamentals is slightly tricky, and I will not discuss the details and types of Financial ModelsTypes Of Financial ModelsFinancial models are used to represent the forecast of a company’s financials based on its historical performance and future expectations to use for financial analysis. The most common financial models include the Discounted Cash Flow model (DCF), Leveraged Buyout model (LBO), the Comparable Company Analysis model, and Mergers & Acquisition model.read more in this article.We note that Alibaba’s Free Cash Flow to the firm is increasing year after yearTo find the valuation of Alibaba, we must find the present value of all the future financial years (till perpetuity – Terminal valueTerminal ValueTerminal Value is the value of a project at a stage beyond which it’s present value cannot be calculated. This value is the permanent value from there onwards. read more)

#6 – Box FCFF – Negative and Growing

On 24th March 2014, Online storage company Box filed for an IPO and unveiled its plans to raise US$250 million. The company is in a race to build the largest cloud storage platform, and it competes with the biggies like Google Inc and its rival, Dropbox. If you want to understand further on how Box is valued, please refer to my article on Box IPO Valuation

Below are the projections of Box FCFF for the next 5 years

 

  • Box is a classic case of high growth cloud company which is surviving due to Cash Flow from FinanceCash Flow From FinanceCash flow from financing activities refers to inflow and the outflow of cash from the financing activities like change in capital from securities like equity or preference shares, issuing debt, debentures or repayment of a debt, payment of dividend or interest on securities.read more (refer Case Study # 1)The box is growing at a very fast pace and should be able to generate Free Cash Flows in the future.Since Box Free Cash Flow to Firm is negative for the next five years, it may not be wise for us to calculate the value of Box using the Discounted Cash Flow approach. In this case, the approach using Relative Valuation is suggested.I am rather scared of this IPO and, in fact, wrote an article on Top 10 Scariest Details of Box IPO. Please note that one of the scariest details in Box IPO is the company’s Negative Free Cash Flow.

7 – Why does Free Cash Flows Matter

  • EPS can be tweaked, but Free Cash Flow to Firm can’t – Though EPS EPS Earnings Per Share (EPS) is a key financial metric that investors use to assess a company’s performance and profitability before investing. It is calculated by dividing total earnings or total net income by the total number of outstanding shares. The higher the earnings per share (EPS), the more profitable the company is.read moreis widely used to measure the company’s performance, however, EPS can be easily tweaked (due to accounting policies gimmicks) by the management and may not necessarily be the best measure for performance. It is best advised to use a measure that is free from accounting gimmicks. Free Cash flow to the firm can be one such measure that cannot be manipulated by Accounting Changes.Cannot go bust soon if Free Cash Flow to Firm positive and growing –Companies that produce consistently higher and growing levels of Free Cash Flows are unlikely to go bust any time soon, and investors should take this into account while investing in the firm.Good indicator for Investors seeking Capital Appreciation – For growth-oriented investors, companies with high Free Cash Flows to the firm are likely to invest their free cash for the Capex Capex Capex or Capital Expenditure is the expense of the company’s total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read morethat are necessary to grow their core business. Growing levels of Free Cash Flows are generally an excellent indicator of future earnings gains.A good indicator for Investors seeking Regular dividends – For income investors, Free Cash Flows can be a reliable indicator of a company’s ability to maintain its dividend or even increase its payout.

Now that you know Free Cash flow to the firm, What about FCFE – Free Cash flow to Equity? Check out a detailed article on Free Cash Flow to EquityFree Cash Flow To EquityFCFE (Free Cash Flow to Equity) determines the remaining cash with the company’s investors or equity shareholders after extending funds for debt repayment, interest payment and reinvestment. It is an indicator of the company’s equity capital managementread more here.

Conclusion

We note that the excess cash generated by the company (CFO+CFI) can be approximated as Free Cash Flow to the Firm. We also note that EPS may not be the best measure to gauge the company’s performance as it is susceptible to accounting gimmicks by the management. A better way to measure the company’s performance by Investment banksInvestment BanksInvestment banking is a specialized banking stream that facilitates the business entities, government and other organizations in generating capital through debts and equity, reorganization, mergers and acquisition, etc.read more and investors is to calculate Free Cash Flow to Firm (FCFF). It looks at the company’s ability to survive and grow without external funding sources (equity or debt). Discounting all future Free Cash Flow to the firm provided us with the Enterprise Value of the FirmEnterprise Value Of The FirmEnterprise value (EV) is the corporate valuation of a company, determined by using market capitalization and total debt.read more. Additionally, FCFF is widely used not only by the growth investors (looking for capital gain) but also by income investors (looking for regular dividends). Positive and growing FCFF signifies excellent future earning capabilities; however, negative and stagnant FCFF may be a cause of worry for the business. 

What’s Next?

If you learned something new or enjoyed this free cash flow to a firm post, please comment below. Let me know what you think. Many thanks, and take care.

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