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).
Free cash flow to firm (FCFF)
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.
Free cash flow to equity (FCFE)
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.
Cash flow ratios
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:
- Cash flow per share: CFO divided by net revenue.
- Cash return on assets: CFO divided by average total assets.
- Cash return on equity: CFO divided by average shareholders’ equity.
- Cash to income: CFO divided by operating income.
- Cash flow per share: (CFO – preferred dividends) divided by the number of common shares outstanding. If dividends are subtracting (under IFRS), they must be added.
Coverage ratios also have CFO in the numerator:
- Debt coverage: CFO divided by total debt.
- Interest coverage: (CFO + interest paid + taxes paid) divided by interest paid. Interest should not be added back if interest is part of financing (under IFRS).
- Reinvestment: CFO divided by cash paid for long-term assets.
- Debt payment: CFO divided by cash paid for long-term debt repayment.
- Dividend payment: CFO divided by dividend paid.
- Investing and financing: CFO divided by cash outflows from investment and financing activities.