Free cash flow

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In corporate finance, free cash flow (FCF) is a cash flow available for distribution among all the security holders of a company. They include equity holders, debt holders, preferred stock holders, convertibles holders, and so on.

Contents

[edit] Common Mathematical formula

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Please improve this article if you can (November 2007).

One of the many objectives once sought to be achieved in the practice of accounting is to determine the maximum amount of liquid cash which can be extracted from an enterprise each period, such that existing levels of productive resources are maintained. Net income is a rough analogue of this metric. Free cash flow has a similar goal, whilst providing a more accurate measure. Free cash flow can be thought of in terms of the amount of "excess" cash which can be "spun out of" (removed from) an enterprise, whilst ensuring sufficient cash reserves remain to maintain (or improve) current levels of production.

Element Data Source
Net Income Current Income Statement
+ Depreciation/Amortization Current Income Statement
- Changes In Working Capital Prior & Current Balance Sheets: Current Assets and Liability accounts
- Capital Expenditure Prior & Current Balance Sheets: Property, Plant and Equipment accounts
= Free Cash Flow

Note that the first three lines above are calculated for you on the standard Statement of Cash Flows.

Element Data Source
Net Income Current Income Statement
+ Depreciation/Amortization Current Income Statement
- Changes In Working Capital Prior & Current Balance Sheets: Current Assets and Liability accounts
= Cash Flows - Operations same as Statement of Cash Flows: section 1, from Operations

Therefore,

Element Data Source
Cash Flows - Operations Statement of Cash Flows: section 1, from Operations
- Capital Expenditure Statement of Cash Flows: section 2, from Investment
= Free Cash Flow

There are two differences between Net Income and Free Cash Flow that should be noted. The first is the accounting for the consumption of capital goods. The Net Income measure uses depreciation, while the Free Cash Flow measure uses last period’s net capital purchases.

Measurement Type Component Advantage Disadvantage
Free Cash Flow Prior period net investment spending Spending is in current dollars Capital investments are at the discretion of management, so spending may be sporadic.
Net Income Depreciation charge Charges are smoothed, related to cumulative prior purchases Allowing for typical 2% inflation per year, equipment purchased 10 years ago for $100 would now cost about $122. With 10 year straight line depreciation the old machine would have an annual depreciation of $10, but the new, identical machine would have depreciation of $12.2, or 22% more!

The second difference is that the Free Cash Flow measurement deducts increases in net working capital, where the net income approach does not. Typically, in a growing company with a 30 day collection period for receivables, a 30 day payment period for purchases, and a weekly payroll, it will require more and more working capital to finance the labor and profit components embedded in the growing receivables balance. The net income measure essentially says, “You can take that cash home” because you would still have the same productive capacity as you started with. The Free Cash Flow measurement however would say, “You can’t take that home” because you would cramp the enterprise from operating itself forward from there.

Likewise when a company has negative sales growth it’s likely to diminish it’s capital spending dramatically. Receivables, provided they are being timely collected, will also ratchet down. All this “deceleration” will show up as additions to Free Cash Flow. However, over the longer term, decelerating sales trends will eventually catch up.

[edit] Alternative Mathematical formula

FCF measures

In symbols:

FCF_t = OCB_t - I_t \,

where

Investment is simply the net increase (decrease) in the firm's capital, from the end of one period to the end of the next period:

I_t = K_t - K_{t-1} \,

where Kt represents the firm's invested capital at the end of period t. Increases in non-cash current assets may, or may not be deducted, depending on whether they are considered to be maintaining the status quo, or to be investments for growth.

Unlevered Free Cash Flow (i.e., cash flows before interest payments) is defined as EBITDA - capex - changes in net working capital. This is the generally accepted definition. If there are mandatory repayments of debt, then some analysts utilize levered free cash flow, which is the same formula above, but less interest and mandatory principal repayments.

Investment bankers estimate Free Cash Flow using the following formula:

EBIT - Taxes

= EBITDA + Depreciation & Amortization - Capital Expenditures - Changes in Net Working Capital

= Free Cash Flows to the Firm (FCFF)

[edit] Uses of the metric

Free cash flow measures the ease with which businesses can grow and pay dividends to shareholders. Even profitable businesses may have negative cash flows. Their requirement for increased financing will result in increased financing cost reducing future income.

According to the discounted cash flow valuation model, the intrinsic value of a company is the present value of all future free cash flows, plus the cash proceeds from its eventual sale. The presumption is that the cash flows are used to pay dividends to the shareholders. Bear in mind the lumpiness discussed below.

Some investors prefer using free cash flow instead of net income to measure a company's financial performance, because free cash flow is more difficult to manipulate than net income. The problems with this presumption are itemized at cash flow and return of capital.

The payout ratio is a metric used to evaluate the sustainability of distributions from REITs, Oil and Gas Royalty Trusts, and Income Trust. The distributions are divided by the free cash flow. Distributions may include any of income, flowed-through capital gains or return of capital.

[edit] Problems with capital expenditures

The expenditures for maintenances of assets is only part of the capex reported on the Statement of Cash Flows. It must be separated from the expenditures for growth purposes. This split is not a requirement under GAAP, and is not audited. Management is free to disclose maintenance capex or not. Therefore this input to the calculation of free cash flow may be subject to manipulation, or require estimation. Since it may be a large number, maintenance capex's uncertainty is the basis for some people's dismissal of 'free cash flow'.

A second problem with the maintenance capex measurement is its intrinsic 'lumpiness'. By their nature, expenditures for capital assets that will last decades may be infrequent, but costly when they occur. 'Free cash flow', in turn, will be very different from year to year. No particular year will be a 'norm' that can be expected to be repeated. For companies that have stable capital expenditures, free cash flow will (over the long term) be roughly equal to earnings.

[edit] Agency costs of free cash flow

In a 1986 paper in the American Economic Review, Michael Jensen noted that free cash flows allowed firms' managers to finance projects earning low returns which therefore might not be funded by the equity or bond markets. Examining the US oil industry, which had earned substantial free cash flows in the 1970s and the early 1980s, he wrote that

[the] 1984 cash flows of the ten largest oil companies were $48.5 billion, 28 percent of the total cash flows of the top 200 firms in Dun's Business Month survey. Consistent with the agency costs of free cash flow, management did not pay out the excess resources to shareholders. Instead, the industry continued to spend heavily on [exploration and development] activity even though average returns were below the cost of capital.

Jensen also noted a negative correlation between exploration announcements and the market valuation of these firms - the opposite effect to research announcements in other industries.

[edit] See also

[edit] References

  • Brealey, Richard A.; Myers, Stewart C.; Allen, Franklin (2005). Principles of Corporate Finance, 8th edition, Boston: McGraw-Hill/Irwin. ISBN 0072957239. 
  • Jensen, Michael C. (1986). "Agency costs of free cash flow, corporate finance and takeovers". American Economic Review 76 (2): 323–329. doi:10.2139/ssrn.99580. 
  • Stewart, G. Bennett, III (1991). The Quest for Value. New York: HarperBusiness. ISBN 0887304184. 

[edit] External links