FCFF (Free Cash Flow for the Firm): Definition & Formula

Instructor: Mark Koscinski

Mark has a doctorate from Drew University and teaches accounting classes. He is a writer, editor and has experience in public and private accounting.

In this lesson, we'll define free cash flow and how it is calculated. You'll learn what free cash flow says about your company's viability and how to use that information to make investing decisions.

Free Cash Flow

The Free Cash Flow (FCF) of a business is defined as the cash flow from operations less both capital expenditures and debt repayment. FCF is often used in financial models for investors to determine the value of a company. Many believe FCF is a superior indicator of a company's value rather than net income, which can be influenced by various accounting methods.

How to Calculate FCF

To calculate FCF, you need to have some basic understanding of a company's financial statements. Every company produces a core group of financial statements, including the footnotes and required disclosures. Among these statements is the statement of cash flows, which provides you with the basic information needed to calculate FCF. The activities of any company can be classified in one of three ways: operating activities, investing activities and financing activities. The cash flows from each of these essential activities are captured on the statement of cash flows and provide you with the information you will need to begin calculating FCF.

Operating Activities

Operating activities include those activities used to determine net income. Examples of these activities include purchasing inventory, paying suppliers and employees, selling products, etc. All statements of cash flow begin with the section detailing cash flows from operating activities. Most cash flow statements reconcile net income as shown on the income statement to cash flows from operating activity.

The most common adjustments include:

  • Depreciation and amortization, which are add-backs to cash flows from operating activities since they are non-cash expenses
  • Changes in working capital, which includes current assets minus current liabilities. The change in working capital is the difference in working capital from the beginning to the end of the year.

The resulting cash flows from operations is the beginning of our computation of FCF.

Investing Activities

Investing activities generally include those affecting long-term assets such as land, buildings and equipment. All companies need at least a minimal amount of equipment to operate. Manufacturing companies often need facilities and large amounts of equipment to conduct their businesses. This requires cash outlays to maintain, grow and keep the plant competitive. That is the reason why capital expenditures are deducted in the computation of FCF. The expenditures for property, plant, and equipment are disclosed in the cash flows used in the investing activities section of the statement of cash flows. It is the second number we need for the computation of FCF.

Financing Activities

Financing activities affect long-term liabilities and owner' equity. Examples include borrowing money, paying back long-term debt such as bonds and cash dividends to shareholders. We are interested in the amount of cash flow the company must use to make debt payments. This is also a required use of cash and is found in the cash flows from financing activities in the statement of cash flows and is the final deduction in our calculation of FCF.

FCF Calculation Example

Let's say you obtained the following information from Company X's statement of cash flows. Cash flows from operations, debt payments and purchase of equipment are $2,000, $500, and $400 respectively for the past year.

To calculate the FCF of Company X, you add the debt payments ($500) and the purchase of equipment ($400) and subtract the sum from the cash flow from operations ($2,000).

$2,000 - ($500 + $400) = $1,100

The FCF of Company X for last year was $1,100.

Trailing FCF and Predicting FCF

Using the statement of cash flows, we have the information needed for calculating the historical FCF of the business. The historical FCF for a 12-month period is called the trailing FCF. If you want to predict the FCF for an upcoming year, there are several other sources of information you will need. These include reviewing the footnotes to the financial statements and other public information about a company. The footnotes should include any material fact affecting a company's future profitability. For instance, a company may issue bonds near the end of the year. The information about the required payment for this new debt, as well as other required debt payments for the upcoming year will be included in the footnotes. This is essential to estimating future FCF since the historical payments will not include the full effect of the new bond issuance.

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