Free cash flow is one of the most important metrics to watch in any business. But if you have a cash flow positive business, how much cash is coming in versus how much is going out? The free cash flow calculator will help you find the answer to that question.
In addition to reviewing the free cash flow (FCF) calculator, this article covers its importance for investors. You will also learn how it can be used for comparing companies and why every company should consider boosting its FCF. Without further ado, let’s dive in!
Free Cash Flow (FCF) – What Is It?
Cash flow is a critical component of sustainability for a business or a project. It is a measure of the ability of a company to generate sufficient cash to offset its cash outflows. Unfortunately, it is the most undervalued metric in the business world. Businesses often focus on profits and expenses but miss the critical component of net cash generated or consumed.
Free cash flow is the amount of cash that a company generates from its operations. In other words, it is a measure of how much money a business makes after it pays for all its expenses. It is important to note that free cash flow is not impacted by the company’s capital expenditures and investments.
With that being said, free cash flow (FCF) can be defined as a firm’s cash that is generated by all of its operations without the cost of capital expenditures. The free cash flow is also known as operating cash flow, or operating profit after tax minus capital expenditure and investment. It can be used to determine the value of a company.
ICFCF & FCFE
There are two types of free cash flows: Invested Capital Free Cash Flow (ICFCF) and Free Cash Flow to Equity (FCFE). The ICFCF is calculated by deducting the sum of long-term debt, finance lease obligations, preferred stock, net working capital, deferred taxes, and minority interest from FCFE. On the other hand, the FCFE is calculated by deducting the sum of the following from net income:
- Interest expense
- Income tax expense
- Depreciation and amortization expense
- Non-cash stock compensation expense, and
- Loss on extinguishment of debt.
Why Should Companies Consider Increasing Their FCF?
The free cash flows are calculated using an income statement that measures all the revenues and expenses incurred in generating profits. You might be wondering why the companies may increase their FCF. There are 3 main reasons to increase free cash flow, including:
- To increase net income;
- To use operating cash in a more efficient way and reduce CCC (cash conversion cycle); and
- To reduce the funds directed to CAPEX.
How to Interpret Free Cash Flow (FCF) – What Does It Suggest to Investors?
As FCF represents the cash that remains after paying every expense we have said earlier, it can be considered the money of the investor. So, as an investor, you should know what it tells you. Free cash flow can be used for different purposes, including:
- Debt principal payments
- Dividend payment
- Shares buybacks
- Acquisitions
When managed properly, each of these things can bring you (or the investor) more wealth over time. That is why it is important to look for a stable and growing free cash flow. If a company you are interested in investing in reduces its FCF, this can indicate a business problem.
One of the major advantages of free cash flow is that it shows issues before EPS (earnings per share) or EBIT (earnings before interest and taxes). That’s because it considers cash flow that comes from operations instead of non-cash costs or non-cash gains. Actually, it takes into account real cash generation or consumption like working capital (accounts receivable), inventory change, and accounts payable. That makes a difference!
Similarly, free cash flow can help investors find out whether the past expansion projects were profitable or not. When used along with the ROIC (Return on Invested Capital), it provides a complete picture of the company’s growth. No matter if the company gets financing through equity or debt, by tracking the FCF, you can reveal its influence on share dilution or debt service (principal + interest).
FCF Formula: How to Calculate Free Cash Flow?
Basically, this formula comprises two components: capital expenditures (Purchases of PP&E) and operating cash flow (also known as net cash flow from operating activities). The information on each of these elements can be received from the company’s cash flow statement. The simple version of this formula is as follows:
Free cash flow (FCF) = Operating cash flow – Capital expenditures
From this equation, we can derive free cash flow so that the FCF formula used by our calculator looks like this:FCF = Sales Revenue – (Operating Costs + Taxes) – Investment in Operating Capital
Where:
- Sales revenue is the total amount of money that a company has earned from selling its goods or services. In order to achieve high sales revenue, a company needs to have a strong product and marketing strategy. It is important to understand the concept of sales revenue and find ways in which the company can increase its sales revenue.
- The operating costs of a business are the total costs required to maintain and operate the business. This includes all expenses from wages, rent, utilities, and other miscellaneous expenses. These costs can be calculated by multiplying the number of employees by their salaries and benefits per year.
- Taxes are imposed on the net income of a business. They can be calculated as the percentage of net income that is due to the government, and it’s usually deducted from each paycheck.
- Investment in operating capital, as its name implies, is the money that is put into working capital. Generally speaking, the more the company invests in operating capital, the more it will be able to grow its business.
Example
To help you understand how to calculate FCF, we will provide an example. Let’s see how to compute free cash flow for the following figures:
- Sales Revenue: $12,000
- Operating Costs: $1,000
- Taxes: $5,000
- Investment in Operating Capital: $2,000
FCF = 12,000 – (1,000 + 5,000) – 2,000
FCF = 12,000 – 6,000 – 2,000
FCF = $4,000