July 01, 2021

Free Cash Flow explained

In simple terms, Free Cash Flow (FCF) refers to the amount of cash generated by the entity after accounting for reinvestment in non-current assets. 

FCF = Cash from Operations [-] Capital Expenditure

Wherein, Cash from Operations = Net Income [+] Non-Cash expense [+] Changes in Net Working Capital. This number can readily be referenced from Cash Flow statement presented by the entity.

Non-Cash expense includes P&L expenses which have not been actually spent in Cash, like - Depreciation, Amortization, Stock based compensation, impairment charges etc.

Working Capital is calculated primarily difference between current asset and current liabilities, like -  Accounts Receivable, Inventory, Accounts Payable, etc.. Change in Net Working capital may be positive or negative number and will need to be added or deducted accordingly

Lot of Equity research report also calculates Levered and Unlevered Free Cash flow. So it's very important to understand the difference between them

Unlevered Free Cash Flow, also called Free Cash Flow to Firm (FCFF)

Levered Free Cash Flow, also called Free Cash Flow to Equity (FCFE)

Main difference between FCF, FCFF and FCFE is with respect to how the interest and debt is treated. Here's quick formula to give an idea on interest / debt treatment.

Free Cash Flow: Includes interest expense, but NOT debt issuances or repayments

Unlevered Free Cash Flow: Excludes interest expense and ALL debt issuances and repayments

Levered Free Cash Flow: Includes interest expense, and mandatory debt repayments

Formula to calculate each:

FCF: Cash Flow from Operations [–] Capital Expenditure

Unlevered Free Cash Flow (or FCFF): Earnings before Interest & Taxes (EBIT) [-] Taxes [+] Non-Cash Adjustments (like Depreciation, amortiztion, stock compensation) [+] Changes in Net Working Capital [–] Capital Expenditure

Levered Free Cash Flow (or FCFE): Net Income [+] Non-Cash Adjustments [+] Changes in Net Working Capital [–] Capital Expenditure [–] Debt Repayments

Note - as we started FCFE from Net Income, tax impact on debt repayment should be adjusted to arrive at more accurate number.

Unlevered free cash flow or FCFF is mostly used while doing discounted cash flow analysis

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