Free Cash Flow to Firm (FCFF) and
Free Cash Flow to Equity (FCFE)
Dr. Manish Dadhich
Definition of Cash Flow
• The incoming and outgoing of cash in a particular
financial year results in the increase or decrease
in the cash position of the company is known
as cash flow.
• It arises due to the activities of the business, i.e.
operating, investing and financing activities. In a
nutshell, the difference between cash at the
beginning and the end of the financial year is
regarded as cash flow for the respective year.
Definition of Free Cash Flow
• The actual cash available with the company, for
distribution it to its security holders, is known as
free cash flow. A positive free cash flow reveals
that the company is generating enough cash to
run the enterprise efficiently.
• However, the Negative free cash flow shows that
the company is not able to generate sufficient
cash, or it has invested money somewhere else
which will generate high returns in the future.
BASIS FOR
COMPARISON
CASH FLOW
FREE CASH FLOW
Meaning
Movement of cash of an
organization, resulting in either
increase or decrease of its cash is
known as cash flow.
Cash available with the
organization to be
distributed among security
holders is known as free
cash flow.
Calculation
The sum total of Operating,
Operating Cash flows less
Investing and Financing cash flows. Capital Expenditure.
Advantage
Helpful in determining the liquidity Helpful in determining a
of the company.
company's financial health.
Scope
It is formalistic and common
phenomenon.
It is more comprehensive
and realistic to the firm
Benefits of Free Cash Flow (FCF)
• Because FCF accounts for changes in working
capital, it can provide important insights into the
value of a company and the health of its
fundamental trends. For example, a decrease
in accounts payable (outflow) could mean that
vendors are requiring faster payment.
• A decrease in accounts receivable (inflow) could
mean the company is collecting cash from its
customers quicker. An increase in inventory (outflow)
could indicate a building stockpile of unsold
products. Including working capital in a measure of
profitability provides an insight that is missing from
the income statement.
Importance of the free cash flow
• Knowing the company’s free cash flow enables
management to decide on future ventures that
would improve the shareholder value.
Additionally, having an abundant FCF indicates
that a company is capable of paying their
monthly dues.
• Companies can also use their FCF to expand
business operations or pursue other short-term
investments. Compared to earnings per share,
free cash flow is more transparent in showing the
company’s potential to produce cash and profits.
Importance of the free cash flow
• Meanwhile, other entities looking to invest may
likely consider companies that have a healthy free
cash flow because of a promising future.
• Couple this with a low-valued share price,
investors can generally make good investments
with companies that have high FCF. Other
investors greatly consider FCF compared to other
measures because it also serves as an important
basis for stock pricing.
Limitations associated with the free cash
flow
• The company’s net income greatly affects a
company’s free cash flow because it also
influences a company’s ability to generate
cash from operations. As such, other activities
(i.e. those not within the core business
operations of a company) from which the
company generates income must be
scrutinized deeply in order to reflect a more
appropriate FCF value.
Limitations associated with the free cash flow
• On the investors’ side, they must be wary of a
company’s policies that affect their declaration of
FCF.
• For example, some companies lengthen the time
to settle their debts to maintain cash or, the
opposite; shortening the time they collect debts
due to them. Companies also have different
guidelines on which assets they declare as capital
expenditures, thus affecting the computation of
FCF.
Types of Free Cash Flow
1. Free Cash Flow to the Firm (FCFF) also
referred to as “unlevered”
2. Free Cash Flow to Equity also knows as
“levered”
1. Free Cash Flow to the Firm (FCFF)
• Free cash flow to the firm (FCFF) represents the
amount of cash flow from operations available
for distribution after depreciation expenses,
taxes, working capital, and investments are
accounted for and paid.
• FCFF is essentially a measurement of a company's
profitability after all expenses and reinvestments.
It is one of the many benchmarks used to
compare and analyze a firm's financial health.
Characteristics of FCFE
1. Free cash flow to the firm (FCFF) represents the cash
flows from operations available for distribution after
depreciation expenses, taxes, working capital, and
investments are accounted for.
2. Free cash flow is arguably the most important
financial indicator of a company's stock value.
3. A positive FCFF value indicates that the firm has cash
remaining after expenses.
4. A negative value indicates that the firm has not
generated enough revenue to cover its costs and
investment activities.
The Formula for FCFF:
• Free Cash Flow to Equity (FCFE) is another cash flow
measure that focuses on cash flows to equity holders
alone.
• FCFE = Net Income + Depreciation – (Change in
noncash Working Capital) – Capital Expenditures –
Net Debt Paid.
• FCFE can also be computed (as an historical quantity)
from the statement of cash flows as
– FCFE = Cash flow from Operations – Capital Expenditures –
Net Debt paid (short-term and long-term)
• If there are other non-common stock securities, cash
flows associated with them, such as preferred
dividends are also subtracted.
• The value of common equity is the discounted
present value of free cash flows to equity.
Another formula
•
•
•
•
•
FCFF=CFO+ (IE×(1−TR))−CAPEX
where:
CFO=Cash flow from operations
IE=Interest Expense
CAPEX=Capital expenditures​
2. Free Cash Flow to Equity
• In corporate finance, free cash flow to equity (FCFE)
is a metric of how much cash can be distributed to
the equity shareholders of the company as dividends
or
stock
buybacks—after
all
expenses,
reinvestments, and debt repayments are taken care
of. Whereas dividends are the cash flows actually
paid to shareholders, the FCFE is the cash flow simply
available to shareholders.
2. Free Cash Flow to Equity
• Free cash flow to equity is the cash flow available to
the company ’ s holders of common equity after all
operating expenses, interest, and principal payments
have been paid and necessary investments in
working and fixed capital have been made. FCFE is
the cash flow from operations minus capital
expenditures minus payments to (and plus receipts
from) debt holders.
2. Free Cash Flow to Equity
• The way in which free cash flow is related to a company ’ s net
income, cash flow from operations, and measures such as
EBITDA (earnings before interest, taxes, depreciation, and
amortization) is important:
• The analyst must understand the relationship between a
company ’ s reported accounting data and free cash flow in
order to forecast free cash flow and its expected growth.
Although a company reports cash flow from operations (CFO)
on the statement of cash flows, CFO is not free cash flow. Net
income and CFO data can be used, however, in determining a
company ’ s free cash flow.
FCFE Formula
Additional Comments

Net Income




(+) Depreciation &
Amortization


(+/-) Changes in
Working Capital



(-) Capex




(+/-) Net Borrowings

Net Income is after the payment of Interest expense.
Net Income can be taken directly from the Income Statement.
You can also find this in the Cash Flow from Operations if the CFO is prepared
using the In-direct method
Add back all the non-cash charges
Generally, this number is found in the Income Statements. In some companies,
Deprecation & Amortization head is not given separately as these expense gets
included in Cost of Goods Sold, SG&A
You can find Depreciation & Amortization figures from the Cash Flow statements
(CFO)
Please note that this cash is either an outflow or an inflow.
Working capital primarily includes Inventory, Receivables, Payables. You may also
include accrued liabilities in this formula.
Short term debt is not included here in the changes in Working Capital
Critical to determining CapEx levels required to support sales and margins in the
forecast
This number can be most easily located from Cash Flow from Investments.
Please note that not only the Capital Expenditure is taken, we must also include
“addition to intangibles”.
Intangibles become important for software/knowledge-based businesses.
Like working capital, this number can also be an outflow or an inflow
This includes both the short term debt as well as the long term debt.
Formula
• Free Cash Flow to Equity Formula Starting from EBIT
• FCFE Formula = EBIT – Interest – Taxes + Depreciation
& Amortization + Changes in WC + Capex + Net
Borrowings
• Free Cash Flow to Equity Formula Starting from FCFF
• FCFE Formula = FCFF – [ Interest x (1-tax)] + Net
Borrowings
Illustration
• Operating profit = 168
NCA = 1345
Income tax expense = 15
Interest on loan = 74
• Depreciation is charged at 10% per annum on the
year end non-current asset balance and is
included in other operating costs in the income
statement.
• The investment in net working capital in Y0 was
220 and in Y1 increased to 240.
Projected cash flows
Year 1
Operating profit
168
Add depreciation (1340 x 10%)
134
Less incremental working capital
(240 -220)
Less taxation
(20)
Less interest
(74)
(15)
––––––
Free cash flow to equity
193
Difference between FCFF and FCFE
Factors
FCFF
FCFE
Cash Flows
Pre Debt Cash Flows
post Debt Cash Flows
Expected Growth
Growth in Operating Income = Reinvestment rate * ROC Growth in Net Income
= Retention ratio * ROE
Discount Rate
WACC
Cost of Equity
Beta
Bottom- up
Bottom-up
• Thx