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Free cash flow is the excess of operating cash flow over capital expenditures. It represents the amount available for payment to providers of capital. There are two measures of free cash flow: free cash flow to firm (FCFF) and free cash flow to equity (FCFE).
FCFF is the cash flow available to providers of both debt and equity capital after all operating expenses and investments required in working capital and fixed capital have been made.
$$ FCFF = NI + NC + I × (1 - t) - FC - WC $$
Where NI is net income, NC represents non-cash charges, I stands for interest expense, t is the tax rate, FC is the fixed capital expenditures and WC is the working capital changes.
Since net income plus non-cash charges minus working capital changes equal cash flows from operations (CFO), FCFF can be expressed as follows:
$$ FCFF = CFO + I × (1 - t) - FC $$
After-tax interest expense is added back because we are determining cash available for both debt and equity. Under IFRS, if a company has classified interest paid as financing activity, we don’t need to add it back. However, if interest and dividends received have been classified as investing (under IFRS), they should also be added to CFO. Similarly, if dividends paid have been classified as operating cash flow, it must also be added.
FCFE, on the other hand, represents the net cash flow available for common shareholders.
$$ FCFE = CFO - FC + Net\ Borrowing $$
Net borrowing is added back because it increases the cash available for common stockholders. If there is a net decrease in debt, net borrowing is negative.
There is a range of cash flow and coverage ratios which can be used to assess the sufficiency of a company’s operating cash flow (CFO) with reference to a number of income statement and balance sheet items.
Almost all cash flow ratios have cash flows from operating activities (CFO) in the numerator:
Coverage ratios also have CFO in the numerator:
by Obaidullah Jan, ACA, CFA on Mon Mar 02 2020
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