Free Cash Flow

Definition

Free Cash Flow (FCF) represents the cash generated by a company’s operations that is available for distribution to all its security holders (debt and equity investors) after accounting for operating expenses and investments, primarily Capital Expenditures (Capex). It measures the discretionary cash flow a company generates.

Significance

• Provides a clearer picture of profitability and financial health than Net Income or EBITDA because it incorporates the cash impact of necessary reinvestment (Capex) and working capital changes.
• Widely used in Valuation, particularly in Discounted Cash Flow (DCF) Analysis.

Two Main Types:

1. Free Cash Flow to Firm (FCFF) - also Unlevered Free Cash Flow (UFCF)

   • Represents: Cash flow available to all capital providers (debt holders, preferred shareholders, common equity holders) before accounting for financing-specific flows like interest.
   • Capital Structure: Independent / Neutral.
   • Common Calculation: $FCFF=EBIT\times (1-TaxRate)+D\&A-Capex-\Delta NWC$ (Note: NWC excludes cash and debt).
   • Usage: Starting point for DCF valued using WACC to arrive at Enterprise Value (EV).

2. Free Cash Flow to Equity (FCFE) - also Levered Free Cash Flow (LFCF)

   • Represents: Cash flow available only to common equity shareholders after accounting for all expenses, investments, and cash flows related to debt (interest, principal repayments/issuance).
   • Capital Structure: Dependent.
   • Common Calculation: $FCFE=NetIncome+D\&A-Capex-\Delta NWC+\Delta NetDebt$. (Note: NWC excludes cash; Net Debt = Debt - Cash).
   • Usage: Starting point for DCF valued using Cost of Equity (Ke) to arrive at Equity Value.

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See also: Capital Expenditures (Capex), EBIT, Net Income, Net Working Capital (NWC), Valuation, Discounted Cash Flow (DCF) Analysis, Enterprise Value (EV), Equity Value