What is Free Cash Flow?
Free Cash Flow (FCF) measures the financial performance of the company. The formula of the FCF is Operating Cash Flow minus capital expenditure. This is an assessment of the amount of cash a company generates after accounting for all capital expenditures, such as building or property, plant, and equipment. The surplus cash is used is used to expand production capacity, develop new products, make acquisitions, pay dividends and reduce debt. Free cash flow enhances shareholder value of the company.
Point to be noted that negative free cash is not bad in itself. If free cash flow is negative, it would sign that a company is making a large investment. If these investments earn a high return, the strategy has the potential to pay off in the long run.
Significance of Free Cash Flow
Free cash flows helps management for taking decision on future ventures that would improve the shareholder value. Additionally, if a company have sufficient free cash flow, it is the indication that the company is capable of paying their monthly dues. On the other hand, the company can also use this additional fund for taking new investment opportunities or considering other short term investment opportunities. Free cash flow is more transparent measurement than Earnings Per Share technique in showing the company’s potential to produce cash and profits.
Prospective investors may consider a company for investment which has a healthy free cash flow because of getting their desired return in future.
Difference between Free Cash Flows and Operating Cash Flows
| Serial No. | Operating Cash Flows | Free Cash Flows |
| 1.00 | The inflow and outflow of cash during a particular financial year is known as operating cash flow. | The Cash left with the company to be apportioned among the shareholders is known as free cash flow. |
| 2.00 | Operating Cash flow discloses the solvency of the company | Free Cash Flows discloses the performance of the company |
| 3.00 | It is calculated by the summation of cash inflow and cash outflows. | Free Cash flow uses only cash from operating activities for its calculation. |
| 4.00 | It is helpful to determine the liquidity of a company. | It is helpful in determining company’s financial health. |
Calculations Procedures of Free Cash Flow
| Earnings before Interest and Taxes (EBIT) | **** |
| Less : Tax on EBIT | *** |
| Operating Income after Taxes | *** |
| Add: Non Cash Items | *** |
| Less: Capital Expenditure | *** |
| Less: Net Working Capital increases | *** |
| Less: Net Working Capital Decreases | *** |
| Add: Salvage Value received | *** |
| Free Cash Flow | *** |
Worked Example
| Earnings before Interest and Taxes (EBIT) | 80,000 |
| Less: Tax @ 21% | (16,800) |
| Operating Income after taxes | 63,200 |
| Add: Non-Cash items (Depreciation) | 14,000 |
| Less: Capital Expenditure | (9,000) |
| Less: Changes to working capital | (1,000) |
| Free Cash Flow | 67,200 |
Conclusion
Free Cash Flow measures how much cash a business generates after accounting for capital expenditure such as buildings or equipment. this cash can be used for expansion, dividends, reducing debt, or other purposes. This cash flow indicates cash sufficiency of the company to expand, develop new products, buy back stock, pay dividends, or reduce the debt.