See also:
Discounted Cash Flow Analysis
Valuation Methods
Free Cash Flow Analysis

Free Cash Flow Definition

The business is like a human body, the body needs blood, the business needs cash. Investor look at Free Cash Flow to make their decision for investment. Interestingly, it’s not a number you can come up easily. First, let’s look at the free cash flow definition. Many business owners, somehow, are not familiar with Free Cash Flow. The Free Cash Flow definition is cash generated by the company after deducting capital expenditures from its operating cash flow the amount of. In other words, after the company pays for employees, debts, expense, fixed assets, rent, plant, etc., whatever money you have got left (“left-over money“) is called Free Cash Flow.

FCF Example

For example, a company has $1 million cash flow from operating activities in its financial statement. However, they are spending more than $900,000 on purchasing property plants or replacing equipment. In this case, the investor will have to analyze the business to see if it was either a poor management decision or a high growth opportunity (i.e. more investment than cash on hand).
Even when a company makes positive Net Earnings, it doesn’t necessarily mean that company has Free Cash Flow.

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Why is Free Cash Flow Important?

As it mentioned above, cash keeps the business running. If your company has Free Cash Flow, then what should the company be spending the money on? They could either hire more employees, invest in other assets, issue dividends, or make more acquisition. Before you make the decision, there are 3 main reasons you would consider FCF as a competitive advantage to maintain the business growth rate.

Free Cash Flow to Equity (FCFE)

FCFE measures the Equity value, referred as “levered” cash flow. It’s the amount of money available for equity shareholders after paying all expenses, debts, reinvestment. Also, consider free cash flow to equity as an adjustment for debt cash flow.

Free Cash Flow to Firm (FCFF)

FCFF measures the enterprise value, referred to as “unlevered” cash flow. Free cash flow to firm shows available cash to all investor – both debt and equity. In an Unlevered Discounted Cash Flow analysis, you would use WACC (Weighted Average Cost of Capital).

Valuation using Free Cash Flow

Other than using DCF method (Discounted Cash Flow), use Free Cash Flow to estimate the present value of a business.
FCF = Present Value.
By calculating free cash flow, you can interpret discretionary cash flow of the company. If FCF is positive, then the company has many options where to put the money in. Whereas if FCF is negative, then you have to analyze if it’s a one-time issue or a recurring problem. If it’s constantly negative, then the company has to raise more money (debt or equity) or eventually has to restructure itself.

Free Cash Flow Formula

The free cash flow formula is very simple. Look at the Cash Flow Statement. Subtract Capital Expenditures from Operating Cash Flow.
Free Cash Flow = Cash Flow from Operation – Capital Expenditures

Operating Cash Flow

Operating cash flow is the amount of money required to fund a company’s normal operation. It’s usually in bold and always show before Financing and Investing Cash Flow. You can also refer to Operating Cash Flow as “Working Capital“.

 Capital Expenditures (CAPEX)

Find Capital Expenditures (CAPEX) in the Cash Flow Statement, under Cash Flow from Investing Activities. However, Capital Expenditures is sometimes listed as Purchase of Property & Equipment. Capital Expenditure is different from Operating Expense (OpEx).
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