When conducting a firm’s ability to handle debts and to expand its business, an analyst looks at different types of free cash flow to reinforce their judgements. These popular
Definition: Free Cash Flow (FCF for short) refers to the cash left a business actually generates from its operation after paying for operational expenditures (operating expenses – OPEX) and capital expenditures (CAPEX). Free Cash Flow helps measure the profitability of a business and the business is free to spend this amount of cash on any purposes such as expanding the operation, paying for debts, investing in other assets, and etc.
1.2 How to Calculate Free Cash Flow
The value of Free Cash Flow can be derived from the income statement, balance sheet, and cash flow statement.
Below is the formula 1 of Free Cash Flow (aka FCF for short)
FCF = NET INCOME + NON-CASH EXPENSES – CHANGE IN NET WORKING CAPITAL – CAPITAL EXPENDITURES
Steps to calculate the FCF using the formula 1:
Step 1: Locate the value of Net Income which appears in the Income Statement.
Step 2: Calculate the Non-cash expenses, which are listed in the income statement and have nothing to do with cash in one reporting period. The non-cash expenses can be broken down like below:
- Depreciation and amortization from the income statement (or easily derived by calculating the difference of accumulated depreciation and amortization between two reporting dates of the year).
- Stock-based compensation which can be taken from the income statement or cash flow statement.
- Other non-cash expenses such as impairment charges and investment gains/losses from the income statement
The sum of all items above are non-cash expenses needed to calculate.
Step 3: Calculate Change in Net Working Capital. You can read Change in Net Working Capital to understand more about how to calculate it and what change in Net Working Capital analysis is. The simplified formula to derive Change in Net Working Capital is:
- Calculate the Net Working Capitals at two different reporting dates – opening date and closing date following the formula : Net Working Capital = Current Assets (Cash and cash equivalent exclusive)- Current Liabilities (debt exclusive)
- Net Working Capital (Current Period) minus Net Working Capital (Previous Period) produces the value of Change in Net Working Capital
Step 4: Calculate Capital Expenditures (CapEx) following the Formula: CapEx = PPE (Closing Balance) – PP&E (Opening Balance) – Depreciation Expenses
- The balance of PPE can be easily taken from the balance sheet
- Depreciation is a line item in the income statement. If you cannot have access to the income statement, you can derive the depreciation charged in a year by calculating the residue of the closing and opening balance of accumulated depreciations.
Step 5: Combine all the components above following the formula of FCF to arrive at the value of FCF
You can easily have the value of those metrics above from the balance sheet and income statement. Another approach to arrive at the value of FCF is from the Cash Flow statement, in which several types of cash flow are presented clearly for you to produce the FCF.
FCF = OPERATING CASH FLOW – CAPITAL EXPENDITURES
Let’s look at the cash flow of Walmart below:
The Operating Cash Flow is 33,596,000, the CapEx is (9,378,000). Operating Cash Flow net CapEx will be the value of Free Cash Flow, which is equal to 24,218,000 at the bottom line of the Walmart Income Statement.
In fact, there are rare income statements with Free Cash Flow calculated as the Walmart Income statement above.
1.3 What is Free Cash Flow Analysis?
We’ve just walked you through how Free Cash Flow was calculated. Yet it is not just a figure, Free Cash Flow is one of the most useful metrics helping analysts to gauge the firm’s overall business health. It looks to answer the question: How much cash does a firm generate from its operational activities, and is it worth for investors to put money in the firm ? A single metric couldn’t indicate the entire picture but it is a very important figure an analyst/ investor could dig in.
We can have either a positive or a negative free cash flow. A positive free cash flow mostly gives analysts a more optimistic picture of a firm’s financial health.
But keep in mind that, analyzing Free Cash Flow might not be applicable to all businesses since it varies by industries. Thus, try to look beyond the numbers, the reasons behind them are indicative of more than what you could picture.
- A negative free cash flow
A negative cash flow MOSTLY means the firm is in a weak finance position because it indicates the firm is unable to generate enough cash to pay for its obligations. Nonetheless, it is not always right. In some cases, the negative cash flow points out the signs of a firm’s future growth if they make wise investments.
For example: A newly established firm operating in an industry that requires acquisitions of assets for growth can lead to the low, or even negative free cash flow. Since it was just founded, an analyst couldn’t have a long line of its performance in multiple years, making it tricky to assess whether or not the firm is unpotential. Initially investing, however, can be indicative of the robust future growth and expansion.
- A positive free cash flow
After covering operational costs and capital expenditures already, there are a number of options for a firm to spend the amount of positive free cash flow:
- The firm can consider spending in capital expenditures for future growth and expansion such as acquiring new assets to increase production, which helps boost long-term growth.
- With available cash on hand from its core operation, the firm could diversify their incomes by investing in different types of investments like stocks, bonds, real estates, etc.
- The firm’s financial health can become better if they pay off a portion of their outstanding debts, making many of its ratios look more attractive in the eyes of investors and other stakeholders.
- Etc
So here’s a thing, can Free Cash Flow be manipulated by accountants or a company?
The answer is YES, though cash flow can be seen as a safer metric than any ratios deprived purely from the balance sheet and income statement, there is still a space for financial statement preparers to manipulate the metric.
Specifically, based on the logic of the formula, the Free Cash Flow can be manipulatively growing by reducing the Operational Expenditures (Operating Costs) to boost the Operating Cash Flow, or investing less in CapEx, which is a deductible amount in FCF formula. In this case, the Free Cash Flow is positive and increasing, but not sustainable in the long term.
On the other hand, it could be a WARNING sign that a firm’s FCF is growing while its sales and profits are declining. There are some ways to have a growing FCF such as manipulating working capitals, non-cash charges, slashing CapEx, increasing non-core revenues.
When conducting the firm analysis, an analyst should grab a trend of how free cash flow has been changing in multiple years to see the relative change in Free Cash Flow and its revenues overtime. For instance, Free Cash Flow has an upward trend while the revenues and profits are falling, or not moving, that’s a point an analyst needs to dig into to see more details.
Those mentioned above are what you might want to look at. Looking beyond the ambiguous numbers enables you to grasp more about the firm’s operation and its cash moving flow.
1.4. The Use of Free Cash Flow
The most basic level of using Free Cash Flow is to analyze and value a company.
A company valuation is based on the net present value of its future free cash flows. To calculate the future free cash flows, assumptions must be made about a variety of factors, including a company’s future sales growth and profit margins, the rate of interests, the cost of capital, and the potential risks to the firm. This article will not dive deeper into the projection of cash flow, it focuses on the use of free cash flow in conducting a DCF for a firm valuation. You are going to project a lot of future free cash flow based on factors listed above, then convert those cash flows into their present value by being divided by suitable denominators. Thus, applying DCF gives you the value of how much a company might be worth.
The Free Cash Flow is also used in Leveraged Buyout Analysis (LBO). LBO means you acquire a company with debt, then the company repays debt overtime. In this case, Free Cash Flow lets you know how much cash the firm is able to generate and how much cash left the firm can pay for the debt each year. You can also know about how much you can pay to acquire a firm upfront, because you can buy a company partially from your cash on hand and the rest with debt.
There are several financial analyses using Free Cash Flow as an important metrics including helping analysts and stakeholders gauge the firm’s FCF performance over multiple years, the rate of growth, factors driving the firm’s growth. Diving deeper, you can analyze CapEx spending, expenses using, revenue streams such as from core business or other activities. That tells all about the company’s business. That’s why knowing FCF deeply is never too early.
2.1 Definition of Unlevered Free Cash Flow
Definition: Unlevered Free Cash Flow (aka Free Cash Flow to the Firm, UFCF and FCFC for short) refers to a Free Cash Flow available to all investors of a firm including Equity and Debt holders. UFCF is a measure of a firm’s cash flow deprived from the firm’s core-business operation.
So these are two important things of Unlevered Free Cash Flow from the definition worth noting:
- UFCF is available to all investors including equity and debt holders.
- It is the cash flow directly generated from the company’s core-business operations.
Unlevered Free Cash Flow, as its name speaks, means the free cash flow is unburdened by interest payments, debt repayments or interest incomes. In other words, when calculating UFCF, amounts related to debts are excluded. Interest income is exclusive because it is not from the firm’s core business operation.
2.2 How to Calculate Unlevered Free Cash Flow
The formula for UFCF is:
UFCF = EBIT*(1-Tax Rate) + NON-CASH EXPENSES – CHANGE IN NET WORKING CAPITAL – CAPEX
Steps to calculate the UFCF/FCFF and explanations:
Step 1: Locate EBIT or Operating Income on the firm’s Income Statement, then multiply by (1-Tax Rate) to arrive at the firm’s Net Operating Profit After Taxes, or NOPAT for short.
Step 2: Take the value of non-cash expenses, presented in the Income Statement or Cash Flow Statement, then add back the non-cash expenses.
Step 3: Factor items which can affect cash flow such as Deferred Income Taxes, but at a basic level, we ignore and don’t mention it here.
Step 4: Calculate the Change in Working Capital, then less the value of Change in Working Capital. Depending on the value of Change in Working Capital, which can be either positive or negative, we could either add or less it.
Step 5: Define Capital Expenditures (CapEx), which can be derived following the formula:
CAPEX = PPE (current period) – PPE (previous period) + DEPRECIATION & AMORTIZATION
- The CapEx has to be subtracted because the firm reinvests this amount of money in acquiring, renovating, and building new assets, causing cash outflow.
For example:
We have EBIT of 29,273,000, let’s say the Effective Tax Rate is 0% for the sake of simplicity.
From the Cash Flow, we have:
- Non-cash Expenses is 6,549,000
- Change in Working Capital is 7,312,000
- CapEx is 9,378,000
Applying the formula gives us the value of UFCF: 19,132,000
2.3 The Use of Unlevered Free Cash Flow
The two purposes of using Free Cash Flow are mentioned at 2. The Use of Free Cash Flow, it includes:
- Analysis
- Valuation.
Similar to Free Cash Flow, Unlevered Free Cash Flow allows investors to analyze a firm and conduct a DCF to determine how much a firm is worth, based on projection.Specifically, future Unlevered Free Cash Flow, projected based on various factors and assumptions, are integral inputs for DCF calculation, with the aim of valuing a firm.
On the other hand, Unlevered Free Cash Flow provides a more attractive number of free cash flow than Free Cash Flow and Levered Free Cash Flow since it excluded interest payments.
Plus, to make a comparison between companies, UFCF is more favored. Each company has its own capital structures, that’s why comparing companies without a consistent capital structure is likely to lead to unfairness against one another. So, to perform comparative analysis, ignoring payment structures and burdens to the debtors could possibly give analysts and investors a clear picture of how the cash flow of a firm has been changing, though of course, UFCF exaggerates the value of cash flow the firm actually has, but we didn’t cover this point here.
Providing a better number for prospective investors, UFCF has a few certain limitations as Free Cash Flow. UFCF can be manipulated easily by the firm and accountants. For instance, the firm could demonstrate a better UFCF by laying off workers to improve EBIT, deferring payments to suppliers to improve Change in Net Working Capitals, and investing less into long-term assets. All of these actions could lead to certain consequences.
When analyzing unlevered free cash flow, it’s important to look at the movement of it over time in multiple years. The worst case scenario could be revenues and unlevered free cash flow are not moving in the same directions, which is totally not good. You could do nothing but dig into details to see each component of UFCF to draw a more concise conclusion.
3.1 Definition of Levered Free Cash Flow
Definition: Levered Free Cash Flow is also referred to as Free Cash Flow to Equity (LFCF or FCFE for short). It is the firm’s remaining cash after covering its financial obligations – debt payments. LFCF is a measure of a firm’s ability to handle dividends to equity investors and to expand its business, as well as to obtain additional LFCF is important in determining how much cash left the firm could use to pay dividends to equity holders and make future investments for the business growth.
3.2 How to Calculate Levered Free Cash Flow
There are a lot of formulas and controversies in calculating Levered Free Cash Flow. However, it’s more important to understand the nature of the Levered Free Cash Flow. And at a basic level, the formula to arrive at the value of Levered Free Cash Flow can be:
LFCF = NET INCOME + NON-CASH EXPENSES – CHANGE IN WORKING CAPITAL – CAPEX – MANDATORY DEBT REPAYMENT
Unlike Unlevered Free Cash Flow, Levered Free Cash Flow takes debts into account. These are steps to calculate Levered Free Cash Flow and short explanations of components in the formula:
Step 1: Start with either EBITDA or Net Income, but applying the formula above, we should start with Net Income on the Income Statement.
Step 2: Non-cash expenses can be taken from the Income Statement or Cash Flow Statement, refer to the previous paragraph of How to Calculate Free Cash Flow.
Step 3: Calculate Change In Net Working Capital, you can visit here to see more details. The Change in Net Working Capital can be either positive or negative, so we less/add the value respectively.
Step 4: Calculate CapEx, as mentioned in the section Unlevered Free Cash Flow. We exclude CapEx because it is a reinvestment in assets, which can be seen as a cash outflow. That’s why we have to subtract it.
Step 5: Locate Mandatory Debt Repayment in the Income Statement or Cash Flow Statement. In some cases, we can’t determine which portion of the item “Repayments of Debt” on the Cash Flow Statement is mandatory or optional. If you don’t have access to the full disclosure of it, you can assume the total value of Debt Repayment on the Cash Flow Statement as Mandatory Debt RePayment, for the sake of simplicity.
For example, we use the pictures above.
3.3 The Use of Levered Free Cash Flow
Quite similar to Free Cash Flow analysis, you can read the analysis of Free Cash Flow for what LFCF can tell you. Of course, the positive is not ALWAYS a good indication, and the negative sometimes speaks something healthy for the firm’s financial performance and operation.
LFCF is an important input of DCF to estimate how much a company might be worth, as UFCF. LFCF, however, is not favored as much as UFCF since the value of it is lower than that of UFCF. So if the investors or the company want to look at a better picture of a firm’s valuation, UFCF always comes to their minds first.
The LFCF is another indicator of a firm’s profitability after it pays for all the mandatory debts. It represents the cash remaining to either invest more or pay to equity investors. Equity investors are mostly less mandatory than debt investors, so if all the debts are net off, LFCF shows more directly about the cash of a firm than UFCF.
Another use case of LFCF is for the firm’s financing. If the LFCF is positive, the firm is likely to conduct financing from loans from debt investors such as banks. The UFCF is far more prefered in valuation, but the LFCF is more accurate.
4. Sum Up and Recap
You have to learn about all types of cash flow: Free Cash Flow, Unlevered Free Cash Flow and Levered Free Cash Flow because they can come up in your interviews at Investment Bank, Private Equity and Hedge Fund. Also, these metrics are used pretty much in your actual jobs at Investment Bank, Private Equity and Hedge Fund.
Now that you’ve walk through all type of free cash flow, let’s take a quick look at the comparison table above, in which we sum up important points for you to easily follow and discern:
Free Cash Flow | Unlevered Free Cash Flow | Levered Free Cash Flow | |
Other names | Free Cash Flow (FCF) | Free Cash Flow to Firm (FCFF) | Free Cash Flow to Equity (FCFE) |
How to calculate? | FCF = NET INCOME + NON-CASH EXPENSES – CHANGE IN NET WORKING CAPITAL – CAPEX FCF = OPERATING CASH FLOW – CAPEX | UFCF = NOPAT + NON-CASH EXPENSES – CHANGE IN NET WORKING CAPITAL – CAPEX | LFCF = NET INCOME + NON-CASH EXPENSES – CHANGE IN NET WORKING CAPITAL – CAPEX – MANDATORY DEBT REPAYMENTS |
Corresponds to | Equity Value | Enterprise Value | Equity Value |
Use Cases | Financial statement analysis | Mostly used in DCF calculation | Inputs for DCF in several certain cases, rarely used |
Whom is it available to? | Equity Investors | Equity and Debt Investor | Equity Investors |
Measures | A firm’s profitability and how much discretionary cash flow generates to expand the operation, pay for debts and invest in other assets | A firm’s cash flow generated from core-business operations, which is available to both debt and equity investors | A firm’s ability to handle dividends and payments to equity investors and to expand its operation |