Free cash flow

In corporate finance, free cash flow (FCF) or free cash flow to firm (FCFF) 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 holders, debt holders, holders, and convertible security holders when they want to see how much cash can be extracted from a company without causing issues to its operations.

Free cash flow can be calculated in various ways, depending on audience and available data. A common measure is to take the earnings before interest and taxes multiplied by (1 - tax rate), add depreciation and amortization, and then subtract changes in working capital and capital expenditure. Depending on the audience, a number of refinements and adjustments may also be made to try to eliminate distortions.

Free cash flow may be different from net income, as free cash flow takes into account the purchase of capital goods and changes in working capital.

Free cash flow can be calculated as follows:

Note that the first three lines above are calculated on the standard Statement of Cash Flows.

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

where

When PAT and Debit/Equity ratio is available:

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

Therefore,

There are two differences between net income and free cash flow. The first is the accounting for the purchase of capital goods. Net income deducts depreciation, while the free cash flow measure uses last period's net capital purchases.

The second difference is that the free cash flow measurement adjusts changes 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 working capital to finance the labor and profit components embedded in the growing receivables balance.

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