Free Cash Flow and Net Free Cash Flow
Free Cash Flow (FCF) is the cash available to stakeholders after all expenses, interest, taxes, capital expenditures, and current portion of long term debt are deducted from revenues.
Free Cash Flow is important to stakeholders (common stock owners, debt holders, preferred stock holders, convertible stock holders, etc.) because it can provide a more accurate picture of an entity’s financial health than net income. Net income includes non-cash accounting adjustments and may not accurately reflect crucial aspects of a company’s health.
FCF is an important and useful metric to evaluate whether a company has sufficient cash resources to meet the goals of the entity and its’ stakeholders.
Related Reading: Types of Cash Flow & Cash Flow Calculations Guide
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Free Cash Flow Calculation
Free Cash Flow (FCF) = Operating Income (revenue – cost of sales) + Depreciation – Taxes +/- Change in Working Capital – Capital Expenditures
Or to simplify:
Free Cash Flow (FCF) = Operating Cash Flow (OCF) – Capital Expenditures
FCF is the cash available to distribute to stakeholders (debt and equity holders) after the bills are paid, and after provisions have been made for future growth of the enterprise. It is important because it represents the money available to enhance shareholders or the owners of the enterprise.
Now let’s take it one step further:
Net Free Cash Flow Calculation
Net Free Cash Flow makes further allowances for capital expenses to keep current levels of operation, the current portion of long term debt, and dividends the company currently intends to pay.
Net Free Cash Flow (NFCF) = Free Cash Flow (FCF) – current capital expenses – current portion of long term debt – current portion of future dividends.
Importance of Free Cash Flow
Use free cash flow calculations to evaluate the strength and health of an organization. A company with a negative FCF may not have the liquidity to stay in business without obtaining additional cash through borrowing or raising equity capital. Falling cash flows are a warning sign that the company that future earnings may not be able to grow.
A company with positive net free cash flow is generating the cash needed to pay operating bills, meet working capital requirement, pay taxes, meet current interest and debt payments, invest in capital expenditures, and pay dividends. Rising cash flows can indicate a company is healthy and many times precedes increasing earnings and enhanced shareholder value.
Related Reading: Company Financial Statements: Analysis and Purpose
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