What it means
Profit on an income statement is not the same as cash. FCFF starts from operating profit and adjusts for taxes, non-cash charges such as depreciation, spending on equipment and changes in working capital, which is the money tied up in inventory, customer invoices and supplier bills.
The result is the cash that really becomes available. The key feature is that FCFF is measured before financing costs.
It does not deduct interest or dividends, so it belongs to both lenders and shareholders collectively. This makes it useful for comparing companies with different amounts of debt.
Analysts use it in discounted cash flow valuation. They forecast FCFF for several years, discount it using the weighted average cost of capital (the blended return required by lenders and shareholders), add a terminal value for later years, and arrive at the value of the whole business.
They then subtract debt to estimate the value to shareholders. A positive FCFF suggests that the business can fund its own investment and still have cash left.
A negative figure is not always bad, because a fast-growing company may be investing heavily, but it means that outside funding is needed. Over time, a healthy company should be capable of producing positive FCFF.
There are different ways of calculating it, which should give the same answer if done consistently. One starts from net income, another from operating cash flow, and another from operating profit as shown here.
Managers should check which version a report is using before comparing figures. FCFF can also be tracked as a margin or a conversion rate.
Dividing it by revenue or by EBIT shows how much of each dollar of sales or operating profit turns into spendable cash, which helps managers compare divisions and spot slippage early.
In practice
Real-world examples.
Example
A private equity analyst values a manufacturer by forecasting FCFF of $280,000 growing steadily. She discounts the cash flows at the company's cost of capital to estimate what the business is worth. The resulting figure is only as good as the growth assumptions behind it.
Example
A chief financial officer of a restaurant group notices that profit is rising but FCFF is flat. She finds that new openings are consuming cash through building costs and stock, so she slows the rollout. The slower rollout protects cash until openings begin to pay back.
Example
A lender comparing two borrowers sees that both have the same profit. One has FCFF of $1,000,000 and the other has FCFF of $100,000, so the lender offers better terms to the first. The lender also checks how stable the cash flow has been over several years.
Formula
Calculation
FCFF = EBIT x (1 - tax rate) + depreciation and amortisation - capital expenditure - increase in net working capital
Suppose a company has EBIT (earnings before interest and tax) of $500,000 and a tax rate of 20%. After-tax operating profit = $500,000 x (1 - 0.20) = $400,000.
Depreciation and amortisation is $60,000, capital expenditure is $150,000 and net working capital rises by $30,000. FCFF = $400,000 + $60,000 - $150,000 - $30,000 = $280,000.Case study
Seen in the real world.
Brightfield Packaging is a fictional company that reported rising profits for four years but kept asking its bank for short-term loans. The new finance director calculated FCFF and found it had been negative in three of the four years.
The cause was a steady growth in unpaid customer invoices and a heavy spend on machinery. In this illustrative scenario, profit looked healthy while cash was being absorbed by working capital and capital expenditure.
The director introduced stricter credit terms and a review of every equipment purchase. Within 18 months, FCFF was positive at $450,000 a year, the loans were repaid and the bank agreed to a lower interest rate. The finance director also began presenting FCFF alongside profit in every board pack, so the directors could see at a glance whether growth was turning into cash.
Watch out
Common mistakes.
- Using net income as a stand-in for FCFF, when it ignores investment and working capital.
- Forgetting to subtract the increase in working capital, which overstates the cash available.
- Deducting interest from FCFF, when the measure is meant to be before payments to lenders.
Questions
People also ask.
What is the difference between FCFF and free cash flow to equity?
FCFF is available to all providers of capital, while free cash flow to equity is what remains for shareholders after debt payments. The two measures are linked through the amount of net borrowing in the period.
Can FCFF be negative?
Yes. Growing companies often have negative FCFF because they are investing heavily, but it must eventually turn positive. Lenders and investors will look closely at how long the negative period is expected to last.
Why is it used for valuation?
Because it shows the cash a business can actually generate for its investors, which is more reliable than accounting profit. It is also harder to flatter with accounting choices than net income.
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