Free Cash Flow

Introduction

This tutorial will explain free cash flow, a crucial financial metric for assessing a firm's operating performance. Understanding free cash flow helps in evaluating how much cash is available for distribution to investors after covering operational expenses. We will cover the definition, calculation method, and provide an illustrative example.

Step 1: Define Free Cash Flow

Free cash flow is the cash generated by a firm’s operating activities after accounting for capital expenditures. It excludes cash flows related to financing decisions, focusing purely on cash generated from operations.

Key Points

• Free cash flow indicates how much cash is available to pay creditors and shareholders.
• It reflects a firm's ability to generate cash from its core business operations.

Step 2: Understand the Calculation Equation

To calculate free cash flow, you can use the following formula:

Free Cash Flow = (Earnings Before Interest and Taxes) * (1 - Tax Rate) + Depreciation - Capital Expenditures - Increase in Net Working Capital

Components Explained

• Earnings Before Interest and Taxes (EBIT): Represents the firm's profitability from operations before any interest or taxes are deducted.
• Tax Rate: The effective tax rate applicable to the firm.
• Depreciation: A non-cash expense added back to reflect the actual cash available.
• Capital Expenditures (CapEx): Money spent on acquiring or maintaining fixed assets, which is subtracted as it represents cash outflow.
• Increase in Net Working Capital: The change in non-cash current assets (like inventory and accounts receivable) minus non-interest bearing current liabilities.

Step 3: Calculate Free Cash Flow with an Example

Let’s work through an example using ABC Manufacturing, which produces beer bottles.

Given Data

• EBIT: 100
• Tax Rate: 40%
• Depreciation: 15
• Capital Expenditures: 35
• Increase in Net Working Capital: 10

Calculation Steps

1. Calculate After-Tax EBIT:

   • After-Tax EBIT = EBIT * (1 - Tax Rate)
   • After-Tax EBIT = 100 * (1 - 0.40) = 60

2. Add Depreciation:

   • Cash flow after adding back depreciation = 60 + 15 = 75

3. Subtract Capital Expenditures:

   • Cash flow after capex = 75 - 35 = 40

4. Subtract Increase in Net Working Capital:

   • Free Cash Flow = 40 - 10 = 30

Result

The free cash flow for ABC Manufacturing is 30. This amount represents cash available for distribution to lenders and shareholders after operational expenses.

Step 4: Alternative Calculation Method

Another way to calculate free cash flow is by using net fixed assets instead of breaking out depreciation and capital expenses:

Free Cash Flow = (EBIT * (1 - Tax Rate)) - Increase in Net Fixed Assets - Increase in Net Working Capital

Note

• Net Fixed Assets: Calculated as Gross Fixed Assets minus Accumulated Depreciation. This method can be useful when specific CapEx or depreciation figures are not provided.

Conclusion

Understanding and calculating free cash flow is essential for evaluating a firm's financial health. By following the steps outlined in this tutorial, you can effectively assess the available cash that can be distributed to investors after covering operational costs. Use this knowledge to make informed investment or business decisions and consider exploring further resources on financial analysis for deeper insights.