Cash is king, or so they say. So, looking at a company’s ability to generate cash is an important step in deciding is its stock is worth investing in. But there are many different types of cash flow. A cash flow statement is included as part of interim and annual results that companies whose stock is listed on the London Stock Exchange issue. That will show operating, investing and financing cash flows as well as the change in the overall cash position.
However, there are alternatives. These are Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE). Both are important financial metrics used to analyse a company’s financial health and value. While they are similar in some ways, they differ in their calculations and the information they provide.
Free cash flow to the firm
FCFF represents the cash flow available to all the capital providers of a company, including equity holders and debt holders. It is calculated by subtracting the company’s capital expenditures and investments in working capital from its operating cash flow. The resulting figure represents the amount of cash the company has left over after meeting its operating and investment needs. This cash can be used to pay dividends, reduce debt, or invest in new projects.
It is possible to calculate free cash flow to the firm (FCFF) from net income by using the following formula:
FCFF = Net Income + Depreciation and Amortization – Changes in Working Capital – Capital Expenditures
Where:
- Net Income refers to the profit earned by the company after accounting for all expenses, taxes, and interest payments.
- Depreciation and Amortization refer to the amount of money that the company has allocated to account for the reduction in value of its fixed assets over time and the allocation of expenses related to intangible assets.
- Changes in Working Capital refer to the difference in the company’s current assets and current liabilities between two accounting periods.
- Capital Expenditures refer to the amount of money spent by the company on buying or upgrading its fixed assets such as property, plant, and equipment.
This formula is based on the fact that net income represents the amount of cash generated by the company from its operations, but it does not take into account changes in working capital or capital expenditures, which are needed to maintain or expand the company’s operations. By adding back depreciation and amortization, which are non-cash expenses, and subtracting changes in working capital and capital expenditures, the formula calculates the cash flow available to all the capital providers of the company.
Free cash flow to equity
On the other hand, FCFE represents the cash flow available only to equity holders. It is calculated by subtracting the company’s capital expenditures and investments in working capital from its net income and adding back any non-cash expenses, such as depreciation and amortization.
The formula for calculating free cash flow to equity (FCFE) is:
FCFE = Net Income – (Capital Expenditures – Depreciation) – Change in Working Capital + Net Borrowing
Where:
- Net Income refers to the profit earned by the company after accounting for all expenses, taxes, and interest payments.
- Capital Expenditures refers to the amount of money spent by the company on buying or upgrading its fixed assets such as property, plant, and equipment.
- Depreciation refers to the amount of money that the company has allocated to account for the reduction in value of its fixed assets over time.
- Change in Working Capital refers to the difference in the company’s current assets and current liabilities between two accounting periods.
- Net Borrowing refers to the amount of money borrowed by the company during the accounting period minus the amount of money that was repaid.
The resulting figure represents the cash flow available to equity holders after all other capital providers have been paid. It is often used to determine the amount of cash available for dividend payments or share buybacks.
FCFE and FCFF are important for both debtholders and shareholders
The key difference between FCFF and FCFE is that FCFF considers the claims of all capital providers, while FCFE focuses only on the equity holders. FCFF provides a broader view of a company’s financial health and its ability to generate cash, as it takes into account the claims of debt holders. It also provides a more conservative estimate of the cash flow available to equity holders, as it includes the cost of debt financing.
FCFE, on the other hand, provides a more specific view of the cash flow available to equity holders. It is a useful metric for investors who are primarily interested in the returns they can expect from their equity investments. However, it does not take into account the company’s debt obligations, which can have a significant impact on the company’s financial health and its ability to generate cash in the long term.
In conclusion, both FCFF and FCFE are important financial metrics that provide valuable information about a company’s financial health and its ability to generate cash. While they differ in their calculations and the information they provide, they should be used together to gain a more complete understanding of a company’s financial situation. If I had to pick one, I would chose FCFF, since FCFE can be inflated by rampant borrowing. That won’t be a problem if a company’s financials are studied in some detail. But it can mislead when financial results are summarised as part of a screen.
The Storied Investor 