Kelvin–Helmholtz mechanism

In corporate finance, free cash flow (FCF) is a way of looking at a business's cash flow to see what is available for distribution among all the securities holders of a corporate entity. This may be useful to parties such as equity holders, debt holders, preferred stock holders, convertible security holders, and so on when they want to see how much cash can be extracted from a company without causing issues to its day to day operations.

The free cash flow can be calculated in a number of different ways depending on audience and what accounting information is available. A common definition is to take the earnings before interest and taxes add any depreciation & Amortization then subtract any changes in working capital and capital expenditure. A number of refinements and adjustments may also be made to try and eliminate distortions depending on the audience and their intentions.

The free cash may be different to the net income for a particular accounting period as the free cash flow takes into account the consumption of capital goods and the increases required in working capital. For example 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 its operations because of the time lag for receivables even though the total profits has increased. If the net income was extracted from the business it would cause cash flow problems for the business.

Calculations

The free cash flow can be calculated as follows:

Element	Data Source
EBIT x (1-Tax rate)	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.

When Net profit and Tax rate applicable are given, you can also calculate it by taking:

Element	Data Source
Net Profit	Current Income Statement
+ Interest expense	Current Income Statement
- Net Capital Expenditure(CAPEX)	Current Income Statement
- Net changes in Working Capital	Prior & Current Balance Sheets: Current Assets and Liability accounts
- Tax shield on Interest Expense	Current Income Statement
= Free Cash Flow

where,

• Net Capital Expenditure(CAPEX) = Capex - Depreciation & Amortization
• Tax Shield = Net Interest Expense X Effective Tax Rate

When PAT and Debit/Equity ratio is available:

Element	Data Source
Profit after Tax (PAT)	Current Income Statement
- Changes in Capital expenditure X (1-d)	Balance Sheets, Cash Flow Statements
+ Depreciation & Amortization X (1-d)	Prior & Current Balance Sheets: Current Assets and Liability accounts
- Changes in Working Capital X (1-d)	Balance Sheets, Cash Flow Statements
= Free Cash Flow

where d - is the debt/equity ratio. e.g.: For a 3:4 mix it will be 3/7.

Element	Data Source
Earning Before Interest and Tax x (1-Tax)	Current Income Statement
+ Depreciation & Amortization	Current Income Statement
- Changes in Working Capital	Prior & Current Balance Sheets: Current Assets and Liability accounts
= Cash Flows from Operations	same as Statement of Cash Flows: section 1, from Operations

Therefore,

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

Difference to net income

There are two differences between Net Income and Free Cash Flow: 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 its 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.

Net Free Cash Flow definition should also allow for cash available to pay off the company's short term debt. It should also take into account any dividends that the company means to pay.

Net Free Cash Flow = Operation Cash flow – Capital Expenses to keep current level of operation – dividends – Current Portion of long term debt – Depreciation

Here Capex Definition should not include additional investment on new equipment. However maintenance cost can be added.

Dividends - This will be base dividend that the company intends to distribute to its share holders.

Current portion of LTD - This will be minimum Debt that the company needs to pay in order to not create defaults.

Depreciation - This should be taken out since this will account for future investment for replacing the current PPE.

If the Net Income category includes the income from Discontinued operation and extraordinary income make sure it is not be part of Free Cash Flow.

Net of all the above give Free Cash available to be reinvested on operation without having to take more debt.

Alternative Mathematical formula

FCF measures

• operating cash flow (OCF)
• less expenditures necessary to maintain assets (capital expenditures or "capex") but this does not include increase in working capital.
• less interest charges

In symbols:

$FCF_{t}=OCB_{t}-I_{t}\,$

where

• OCB_t is the firm's net operating profit after taxes (Also known as NOPAT) during period t
• I_t is the firm's investment during period t including variation of working capital

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 K_t 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 - taxes. 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 compute Free Cash Flow using the following formulae:

FCFF = After tax operating income + Noncash charges (such as D&A) - Capex - Working capital expenditures + Interest*(1-t)= Free Cash Flows to the Firm (FCFF)

FCFE = Net income + Noncash charges (such as D&A) - Capex - Change in Non Cash Working Capital + Net Borrowing = Free Cash Flows to the equity (FCFE)

Or simply:

FCFE = FCFF + Net borrowing - Interest*(1-t)

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.

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

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.

See also

• Business valuation
• Discounted cash flow
• Enterprise value
• Economic value added
• Owner earnings
• Weighted average cost of capital

References

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• 20 year-old Real Estate Agent Rusty from Saint-Paul, has hobbies and interests which includes monopoly, property developers in singapore and poker. Will soon undertake a contiki trip that may include going to the Lower Valley of the Omo.
  
  My blog: http://www.primaboinca.com/view_profile.php?userid=5889534

External links

• Free Cash Flow: Free, But Not Always Easy, Investopedia
• What is Free Cash Flow?, Morningstar

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