What is free cash flow and how do I calculate it?
A summary provided by
Pamela Peterson Drake, Florida Atlantic University
CONTENTS:
Estimates of cash flows .................................................................................................................... 1
Free cash flow ................................................................................................................................. 2
Free cash flow and agency theory .................................................................................................. 3
Free cash flow to equity ................................................................................................................ 3
Free cash flow to the
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The calculation uses information from both the company’s income statement and its balance sheet:
(EQ 3)
CFO =
Net other non-cash increase in
+ depreciation + amortization + income charges (income) net working capital
Net working capital is defined as:
(EQ 4)
Net working capital = Current assets – current liabilities
Therefore, if net working capital increases, this is an offset to cash flow from operations, whereas if net working capital decreases, this is an enhancement of the cash flow from operations.
Cash flow from operations is a key indicator of a company’s financial health, because without the ability to generate cash flows from its operations, a company may not be able to survive in the future: cash flows are the lifeblood of a company.
Free cash flow
It has always been recognized that cash flow, no matter how we calculated it, does not necessarily reflect what was available for the suppliers of capital (that is, creditors and owners). An alternative cash flow, known as free cash flow (FCF), is useful in gauging a company’s cash flow beyond that necessary to grow at the current rate. This is because a company must make capital expenditures to continue to exist and to grow and FCF considers these expenditures.
In analysis and valuation, the essence of free cash flow is expressed as cash flow from operations, less any capital expenditures necessary to maintain its current growth:
(EQ 5)
Free cash flow = CFO - capital
3. Was cash flow from operations greater than or less than net income? Explain in detail the major reasons for the difference between these two figures.
Cash on hand and Assets are important to account for when expanding into a new product line. When an accurate balance sheet is presented and all proper accounting is done, the company is able to leverage their financial strengths and not expose weaknesses when expanding into a new product line. The reasoning for such a strong focus on the balance sheet is to ensure that the capability to expand is present financially. Companies that have cash on hand and assets are displaying a positive indicator because it shows the ability to act and invest on demand. According to (Martin, 2002) “Cash is king regarding solvency, but customers shouldn't overlook a company's cash-burn rate” what this means is that even though there is cash on hand the ability to go through it is present especially when launching a new product lines in which case the ability to replenish cash reserves must present in the form of revenues.
While net cash is critical to determine the ability of the organization to meet its immediate requirements, the non-cash factors that are included in the net income calculation portray a more accurate view of the long-term profitability. Also because of the timing differences between when revenue and expenses are recognized, the accrual method behind the net income model will produce visibility that is more accurate. For example, a month that produces low volume of sales and a high volume of receivable could produce a positive cash flow when in reality that low sales volume will negatively affect the subsequent months. This variance would be visible in the net income but would not be visible in net cash.
A measure of financial performance calculated as operating cash flow minus capital expenditures. Free cash flow (FCF) represents the cash that a company is able to generate after laying out the money required to maintain or expand its asset base. Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it's tough to develop new products, make acquisitions, pay dividends and reduce debt.
The free cash flow method is used to gauge “a company’s cash flow beyond that necessary to grow at the current rate… [to ensure companies] make capital expenditures to continue to exist and to grow” (Drake, n.d.). Calculation of free cash flows utilizes various components, including a firm’s value, cash flow forecasts, a firm’s capital structure, the cost of capital, and/or discounted cash flows.
Working or functioning capital is the extent at which the organization’s cotemporary possessions enhanced from the liabilities. In this scenario group A evaluate the financial statement of Wal-Mart that includes balance sheets, cash flow statements, and suggestion by the managerial administration along with the postscripts to the financial statements of account that needs to demonstrate how every existing resource as well as liability has influenced the tactics that are concerned with the cash management administration. Moreover perceiving the upcoming year’s prediction of Wal-Mart’s profitability or income would boost up by 20%, we then give a diversified suggestion concerning working
Imagine you were John Olson. You are an energy analyst for Merrill Lynch. Your boss, Donald Sanders, shows you a hand-written note from one of Merrill’s largest customers. It reads in part, ' 'Don -- John Olson has been wrong about … our company… for over 10 years and is still wrong, … Ken ' ' Merrill subsequently fired him because he refused to endorse the customer’s exaggerated profit claims.
Free cash (Athanassakos, 2009, p. 1) is the economic evaluation of a firm’s ability to maintain after tax flows of cash over time and regardless of product or service. The calculation:
Trade debts mean that money can often be tied up for as much as sic
Furthermore, if an organisation does not have enough cash resources in order to settle its current liabilities, this will highlight great inefficiency with stock turnover not being sold. A good company such as Sainsbury’s we see is healthy because revenue is recognised from inventories sold – this revenue allows cash to flow in order to pay for short term and long-term liabilities. It is evident that there are insufficient cash flowing into the company from investing activities and financing activities, which are shown by the brackets.
| Below is an excerpt from the cash flow statement of a firm for fiscal year 2003: Cash flows from operating activities: Net income Adjustments to reconcile net income to net cash provided by operating activities: Depreciation and amortization Amortization of software Tax benefits of employee stock plans Special charges (Gains)/losses on investments Change in operating assets and liabilities: Receivables Inventories Pension assets Other assets Accounts payable Pension liabilities Other liabilities Net cash provided by operating activities Cash flows from investing activities: Payments for plant and other property Proceeds from disposition of plant and other property Investment in software
In corporate finance, free cash flow (FCF) is cash flow available for distribution among all the securities holders of an organization. They include equity holders, debt holders, preferred stock holders, convertible security holders, and so on.
According to [Fernandez, 2002], the most important types of cash-flow are the Free cashflow (cash-flow available to satisfy both the shareholders’ and creditors’ return requirements), the Equity Cash-flow (cash-flow available for shareholders) and the Debt Cash-flow (cash-flow available for creditors). 14
This section reflects the underlying health of the business thus making it the most important section of the cash-flow statement. The ability of a firm to fund its operating capability, repay loans, pay dividends etc are indicated by the cah flows arising from operating activities.
Cashflow is bloodline to every business and keeps oiling it like a machine. As a rusty machine can stop functioning so can a business. Whether it is business investment, growth or dividend payment, you will need smooth cashflow management