Free Cash Flow (FCF) is a crucial financial metric that represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It signifies the cash available to all investors (both debt and equity holders) after the company has paid for its operating expenses and capital expenditures. Essentially, it's the "free" cash a company can use for things like paying dividends, repurchasing stock, reducing debt, or making acquisitions.
Why is Free Cash Flow Important?
Liquidity and Solvency: A strong and positive FCF indicates a company's ability to meet its financial obligations and invest in growth.
Valuation: FCF is often used in valuation models, such as the Discounted Cash Flow (DCF) model, to estimate a company's intrinsic value.
Financial Health Indicator: It provides a clearer picture of a company's financial health than net income, as net income can be influenced by non-cash accounting items.
Management Effectiveness: Positive and growing FCF can reflect efficient management of operations and capital.
How to Calculate Free Cash Flow
There are a couple of common ways to calculate Free Cash Flow. The formula implemented in this calculator is a widely accepted method that starts with operating income and makes adjustments for taxes, capital investments, and changes in working capital.
Method 1: Using Operating Income (EBIT)
The formula is:
FCF = Operating Income * (1 - Tax Rate) + Depreciation & Amortization - Capital Expenditures - Change in Net Working Capital
Alternatively, if you have the exact amount of Income Taxes Paid, you can use:
FCF = Operating Income - Income Taxes Paid + Depreciation & Amortization - Capital Expenditures - Change in Net Working Capital
Where:
Operating Income (EBIT): Earnings Before Interest and Taxes. This is the profit from a company's core business operations.
Income Taxes Paid: The actual cash taxes paid by the company. If not directly available, it can be estimated using the effective tax rate applied to EBIT.
Depreciation & Amortization: These are non-cash expenses that are added back because they reduced taxable income but did not involve an actual outflow of cash.
Capital Expenditures (CapEx): The cash spent by a company to acquire or upgrade physical assets like property, plant, or equipment.
Change in Net Working Capital: This represents the difference in net working capital (Current Assets – Current Liabilities) between the current period and the prior period. An increase in NWC typically consumes cash, while a decrease frees up cash.
Example Calculation:
Let's say a company has the following figures for a year:
Operating Income (EBIT): $150,000
Income Taxes Paid: $30,000
Depreciation & Amortization: $10,000
Capital Expenditures (CapEx): $25,000
Change in Net Working Capital: $5,000 (an increase)