Free Cash Flow (FCF)

Understand (What is it)

Free cash flow (FCF) is the cash flow available for distribution to investors after deducting all necessary deductions like the investments in working capital and non-current assets to sustain the ongoing operation. It is used to understand true profitability of a company, investors often prefer those companies which have higher FCF, because it may help for future expansion, pay the dividend and reduce debt etc. The formula to calculate FCF is as under:

Free Cash Flow (FCF) = Earnings before interest and tax (EBIT) + depreciation & amortization – capital expenditure – change in net working capital

Example (How it works)

The recently published accounts of AB plc show the following figures:

Earnings before interest and tax = $200

Depreciation = $15

Capital nature expenditure like purchase of building = $50

Tax rate on income @ 35% = $70

Solution

FCF = 200 +15 – 70 -50 = $95

Use of Free Cash Flow (FCF)

Although it is a good tool to evaluate a company with help of FCF and considered better indicator than P/E ratio, however investor should also be aware that companies can alter their FCF, for example by delaying payments of bills to next year in order to increase the profit. Further, negative free cash flow may not be the bad sign because it could be a sign that the company is making heavy investments.

It also helps to determine the equity value in the cash-based approach of business valuation where the value of equity is the sum of future free cash flows discounted at the cost of equity.

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