Free Cash Flow (FCF)

Free Cash Flow (FCF)

Free Cash Flow (FCF) is the amount of cash that a company has left over after it has paid all of its expenses, including investments. It is the cash that a company is able to generate after laying out the money required to maintain or expand its asset base.

Free Cash Flow (FCF) is a measure of financial performance calculated as operating cash flow (net income plus amortization and depreciation) minus capital expenditures and dividends.

How is Free Cash Flow FCF used?

Free Cash Flow is a source of financing. It allows companies to take advantage of new opportunities. Without free cash flow, a company would be unable to develop new products, acquire other businesses, pay off debt, and pay dividends to shareholders.

Implications for shareholders

Free Cash Flow is also closely tied to the amount of cash that is left over for the stockholders. The more free cash flow a company has, the more likely it is to pay high dividends.

Free Cash Flow FCF in layman terms

To produce revenue, a firm incurs operating expenses. That is for example office paper, paper clips, free coffee. In more broad terms, it would be especially the following:

  • salaries,
  • cost of goods sold (CGS),
  • selling and general administrative expenses (SGA),
  • research and development (R&D)).

The difference between operating revenue, that is what the firm gets from customers, and operating expense, the list of things above, is called Operating Income or Net Operating Profit (NOPAT).

A firm also must buy machinery, buildings, tools, and other things. The firm must invest money in real estate, buildings, and equipment.

In addition to this, a firm also needs to buy inputs for its production. It has to buy lumber if it wants to manufacture showels. In financial terms, a firm has to purchase working capital to support its business activities.

On top of that, a corporation must pay income taxes on its earnings.

The amount of cash that is left over after the payment of all these expenses, investments, and taxes is known as Free Cash Flow (FCF).

Formula for the Free Cash Flow FCF

Free Cash Flow (FCF) can be calculated in two ways.

   Net Operating Profit
 - Taxes
 - Net Investment
 - Net Change in Working Capital
 = Free Cash Flow (FCF)

Or, alternatively:

   Net Income
 + Amortication/Depreciation
 - Changes in Working Capital
 - Capital Expenditures
(- Dividends)

 = Free Cash Flow (FCF)

The Dividends are in parentheses because some analysts include them, some do not. When analyzing Free Cash Flow, it is important to always know how the figure was calculated.

Is there any other ratio related to this metric?

Yes, financial practice know many other ratios, for example the following:

Cash Asset Ratio (CAR),

Capital Adequacy Ratio (CAR),

Acid Test Ratio,

Current Ratio (CuR),

Return On Assets (ROA),

Return on Investment (ROI),

or the Return On Equity (ROE).


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