In this article, I’m going to talk about free cash flow specifically what free cash flow is and how you would go about calculating it? So let’s start with defining it, free cash flow we’re talking about cash flow that has to do with the firm’s operating decisions, and by operating decisions, we’re specifically excluding the firm’s financing decisions. So this is cash flow that does not have to do with the firm’s financing decisions.
What do mean here? What are we talking about? Well, when a firm generates sales it’s going to have cash from those sales typically or accounts receivable that it converts to cash, in any event, the firm is generating cash otherwise it wouldn’t exist and now the firm is going to reduce that cash when it pays employees when it pays the electric bill and so forth. It’s going to be reducing the cash that it’s received. So when we have that going on ultimately we’re going to have some net cash flow or some cash flow that’s leftover and what happens is that that cash flow that’s leftover now it’s going to go to two primary groups, you’ve got this.
We’ll say this cash flow gets leftover goes to lenders that’s who’s going to have the first claim on it this is like bank bondholders and so forth in the second group would be the owners of the firm so whatever doesn’t go to the lenders in terms of interest payments and so forth is going to end up going to the owners and if this is a publicly-traded firm then we’re talking about the shareholders of the firm so ultimately the firm generates cash through sales through revenue then it goes ahead and pays the employees that pay their bills and then you’re left with some cash and then the firm takes that cash and it has to pay its lenders first assuming it has borrowed money and then whatever’s left over the owners have a claim on that.
So when we’re talking about free cash flow, we’re talking about the cash flow that’s leftover before it’s distributed to lenders and owners. So before any interest is paid before any dividends are paid to the owners what’s the cash flow before that happens? So when we think about this, we can look at it in terms of an equation that we use to calculate free cash flow, making it a little bit easier for you to understand.
Cash flow formula:
So on the left side we’ve got free cash flow and the way we’re going to calculate that we’re going to start with earnings before interest and taxes (EBIT) okay and then we’re going to multiply that by (1 – the tax rate) now why are we doing this? Why don’t we just take for example net income? We don’t look at net income because we want to get the effect before any interest is paid. If we just looked at net income then we’re already factoring in the interest tax shield and that’s something we said we don’t want to deal with because we’re sending with cash flow before considerations about financing decisions or things involving lenders or the owners or any kind of financing activities at all.
So we’re taking earnings before interest and taxes (EBIT) and then we’re scaling that by (1 – the tax rate) because we’re going to deduct out the cash flows from that, not considering the tax shield from the interest. Then we’re going to add back depreciation because as you know depreciation is a non-cash expense and that was something that was deducted in calculating earnings before interest in taxes so we’re going to add that back. Then we’ve got to subtract out capital expenditures as you know we’re not expensed in terms of earnings before interest and taxes (EBIT) but it was a cash flow so we have to go ahead and we have to back out the CAPX and because as we spend money on machines or equipment that money is obviously not available to lenders and owners for distributions and lastly we’re going to subtract an increase in Net Working Capital that took place during the period.
Now we’re talking about the increase in Net Working Capital specifically we’re talking about Non-cash current assets. So inventory, accounts receivable are those types of assets, and then we’re going to subtract out the Non-interest-bearing current liabilities. So we’re basically taking the current assets, not including cash, so whatever the current assets are deducted cash those net current assets, and then we’re going to subtract out any current liabilities that are not bearing interest. So for example some current personal portion of long-term debt would not be included even though it’s a current liability that’s an interest-bearing current liability so that would not be factored into our calculation of the increase in that working capital.
An example of Free cash flow (FCF):
So this is our equation that we go ahead and we use to calculate this but let’s look at an example:
Let’s say a firm that manufactures bottles ABC manufacturing they make beer bottles. So we can go ahead and calculate the free cash flow. So we can just use our formula from above we see here we’ll just take the free cash flow is just going to be the earnings before interest and taxes (EBIT) times (1 – the tax rate) + Depreciation – CAPX – the increase in net working capital. If you go ahead and you calculate out what you’re left with is the free cash flow of 30.
An alternative way of calculating:
So that’s the amount of cash flow to the firm after the firm’s operations but before considering any financing effects or financing decisions that the firm is made. Now it just bears mentioning that there’s an alternative way to calculate free cash flow here. You can also calculate free cash flow as equal to earnings before interest and taxes (EBIT) times (1 – the tax rate) but instead of looking and breaking out specifically by depreciation and CAPX what you can go ahead and subtract out the increase in net fixed assets which I’ll abbreviate NFA, increase in net fixed assets and then, of course, you still take out the increase at net working capital.
So sometimes you might have a professor gives you a problem and they don’t specifically give you depreciation and CAPX or something but you have a balance sheet you can see the change from the previous year balance sheet you can see the change in the net fixed asset you can go ahead and still calculate free cash flow. When we look at these net fixed assets, we’re talking about (Gross fixed assets – Accumulated depreciation) and if you calculate a free cash flow, using this will get you to the same place as our original equation for free cash flow.