Free cash flow (FCF) is more valuable than the net profit (PAT) of a company. We will see how. To understand it, we will use a hypothetical example and calculate the free cash flow for an individual.
Suppose you won a prize in a car rally. The gift is payable in cash worth Rs.5,00,000. But it will be paid in two installments. The first installment of Rs.3,00,000 will come in the current year, and the balance of Rs.2,00,000 will come in the next year.
In your personal financial report, you can show Rs.5,00,000 as income for the current year. But your cash in-flow in the current year will be only Rs.3,00,000.
- You’ve paid in cash Rs.2,00,000 towards the modification of the car to enhance its performance. It will your cost of CAPEX.
- You’ve also paid in cash Rs.1,50,000 towards refueling and general maintenance of the car.
Considering the above data, let’s calculate your net profit (PAT) and free cash flow (FCF):
The free cash flow in this example is negative. Though the company looks profitable in the P&L account, a negative FCF will yield it only zero intrinsic value. The value investors like Warren Buffett will stay away from such companies.
What is Free Cash Flow (FCF)?
Free cash flow is really free cash available with the owners of the company. It is free because it has no immediate obligations. If the owners want, all of it can be availed as dividends.
FCF is free because it is the extra cash. The owners have it at the end of the financial year, after payment of all current liabilities, including interest (in case of FCFE), and also taxes.
We’ll know what is FCFE and FCFF later in this article. For the moment, let’s get more introduction about FCF.
FCF helps the investors to analyze the current profitability of the company by removing all non-cash transactions.
Significance of FCF?
When shareholders talk about free cash flow, they actually mean Free Cash Flow to Equity (FCFE). FCFE is the owner’s cash that is free from obligations, including the dues payable to the borrowers.
The owners (shareholders) are free to retain the FCFE within the company or pay a part of it as dividends.
Retained FCFE can be used for clearing debt, strengthing working capital, shares buyback, increasing R&D funding, taking up new marketing plans, acquisitions, buying investments, etc. All these activities are done to enhance the shareholder value over time.
For shareholders, the bigger will be the quantum of FCFE, the higher will be their potential returns. How?
- In short term, they can earn more in terms of dividends.
- Upon FCFE’s reinvested, the company’s market share will grow yilding higher returns in long term for the shareholders.
Types of FCF
There are two types of people who invest in a company, borrowers and equity holders.
Borrowers lend money (debt) for a fixed return called interest. Equity holders lend money for a stake in the company’s profits.
Free Cash Flow is free cash available for distribution to both borrowers and equity holders.
There are two variations on FCF – FCFF and FCFE.
When we generally use the term FCF, we are referring to Free Cash Flow To Firm (FCFF). FCFF caters to both borrowed and equity holders. Free Cash Flow To Equity (FCFE) caters only to the equity holders.
The mathematical difference between FCFF and FCFE can be seen in this formula:
FCFF = FCFE + Net Borrowed Debt – Interest * (1-tax rate)
|Description||It is free cash available for both borrowed and equity holders||It is free cash available for equity holders (shareholders) only|
|Debt Consideration||FCFF does not consider the effect of debt on the free cash available to the company.||FCFF considers the effect of debt on the free cash available to the company. It adds new debt to FCFF, substracts principal, and interest paid off the existing loans.|
|Discount rate consideration while using DCF Model||Weighted Average Cost of Capital (WACC = Cost of Debt + Cost of Equity)||Only Cost of Equity (or return expectations of the shareholders)|
|Preference of equity investor||NO||YES|
FCF & Intrinsic Value
In the estimation of intrinsic value, the correct calculation of free cash flow is essential. Accurate will be the FCF calculation, precise will be the intrinsic value estimation.
In this article, we will learn about how to calculate the FCF of a company.
How To Calculate Free Cash Flow?
Analysts prefer the use of the Cash Flow Report because it deals only in cash. It removes the account receivables because it is a non-cash item. Similarly, all non-cash expenses which are still not paid, or have been paid in advance, are removed.
As one is calculating the quantum of free cash flow, the numbers appearing in the cash flow report, which is the net of non-cash items, look more apt.
From Cash Flow Report
Look into the cash flow report and all the numbers required to calculate FCF are neatly available. Hence, the best way is to download the cash flow statement from the company’s website, and then do the FCF calculation
The first required number is Cash PBIT. This number includes the interest expense and is net of the actual tax paid. Check its formula.
Cash PBIT = PAT + (Tax Expense – Tax Paid) + Interest Expense
Why the interest expense is added back to PAT? It is because of two reasons:
- First, interest is not an operating expense. It will be visible under the head cash flow from financing activities.
- Second, to calculate FCFE, we need actual interest paid in cash and not the total interest expense shown in the P&L account.
Once the Cash PBIT is known, it must be adjusted for any non-cash transactions. After all non-cash items are adjusted, what is left is called net cash flow from operating activities.
Now, the below formula can be used to calculate FCFF and FCFE:
FCFF = Net Cash From Operations – CAPEX
FCFE = FCFF + Net New Debt – Interest Paid
The value of Capex and the actual interest paid are clearly visible in the cash flow statement. Suggested Reading: How to read cash flow report.
In case, cash flow report available is not as detailed, the balance sheet and P&L reports can be used to calculate FCF.
[P.Note: I will like to add here that, cash flow reports download from the company’s website are detailed. But some financial websites like economictimes, moneycontrol, etc present non-detailed cash flow statements of companies.]
From Balance Sheet and P&L A/c
There are cases where the company has reported a positive PAT in P&L account but upon calculation, its FCF came negative. Negative FCF means, its intrinsic value will be zero.
In intrinsic value calculation, experts prefer the use of Free Cash Flow instead of PAT. Why? Because free cash flow is a more accurate representation of cash profits available in the hands of the owners.
The below schematic representation highlights the difference between Net Profit (PAT) and Free Cash Flow (FCFF & FCFE).
Allow me to explain each of the ingredients of the Free Cash Flow formula.
1. Net Profit (PAT)
PAT is the estimated income after adjusting all expenses. This expense includes mandatory depreciation and amortization, interest, and income tax.
There is a general perception that net profit is the profit of the owners. But in reality, it is not. To keep running a business profitable and growing, there are a few additional strategic expenses that must be accounted for.
Adjustment of all these strategic expenses, and non-cash transactions, gives the actual profit of the owners, called free cash flow.
The strategic expenses could be like prepayment of debt, funding Capex, funding of the increase in working capital, etc.
2. Depreciation & Amortisation (D&A)
This is a non-cash expense reported in the company’s income statement. It is the adjustment of Capital Expenditures (CAPEX) already made by the company in the past.
What does it mean? It means, the depreciation visible in the financial report is just a number. The actual cash flow has already happened in the past. All of this cash flow of the past was not accounted for in the same year of its occurrence. As per GAAP, the CAPEX can be adjusted, as depreciation cost, throughout the life of the new asset.
For example, an asset worth Rs.100 crore was purchased by the company. The payment of it (Rs.100 Cr) was made in the Year 2021. The life of the purchased asset is 8-Years. So the company can book the total CAPEX in all of the next 8 years. Hence, in Yr-2022 it will book depreciation of Rs.12.5 crore. The same will be repeated for the next 7 years. At the end of the eighth year, the full cost of the asset would have been adjusted (12.5. x 8 = 100).
As depreciation is a non-cash expense, hence in the estimation of free cash flow, we can add this expense back to PAT. It then represents the actual cash available in the hands of the company.
3. Interest Expense
In FCFF, we are calculating the free cash flow available to all types of investors of the company (borrowers and equity holders). Hence, the effect of debt is not taken into consideration.
How does debt affects the company? In three ways, increase in cash flow, increase in interest expense, and tax savings due to interest paid.
In the calculation of FCFF, the three effects of debt are not considered. Why? Because here we want to know the free cash available for both borrowers and shareholders.
4. Increase in Working Capital
Let’s first know about the components of working capital.
- Current Asset (CA): Total liquid assets which can be converted into cash in next one year. Example of such assets is account receivables, raw material, work in progress, finished good inventory, pre-paid liability (advance), savings deposits, etc.
- Current Liability (CL): Total liability that must be paid in next one year. Example of such liability is account payables, interest dues, income tax dues, short term debts etc.
Working Capital (WC) = CA – CL
Significance of Working Capital: We are in the year 2020. Suppose a hypothetical company ABC reported Rs.100 Cr in the current asset (CA) in FY2019. The company also reported an immediate obligation of Rs.75 Cr in current liability (CL).
It means, out of the available Rs.100 Cr, Rs.75 Cr is already booked to handle current liabilities for the past year 2019. Hence, what is available for the year 2020 is only Rs.25 Cr.
WC (Rs.25 Cr) = CA (Rs.100 Cr) – CL (Rs.75 Cr)
This Rs.25 Cr is what we call working capital. This is the net available fund generated by the company’s operations in the year 2019, that can be used to fund the operational needs in the year 2020.
Suppose there is another hypothetical company XYZ which reported Rs.120 Cr. in the current asset (CA) in FY2019, and Rs.130 Cr in current liability (CL). As CL is more than CA, hence its working capital will be negative.
WC (-Rs.10 Cr) = CA (Rs.120 Cr) – CL (Rs.130 Cr)
Negative working capital means, in 2019 the company has not generated enough cash to fund its current liabilities. As a result, for 2020 the company starts with zero WC.
Moreover, in 2020 it must also ensure enough current assets to take care of the current liability deficit for 2019 and to meet the forthcoming current liabilities requirement for 2020.
Effects of Change in WC
How does change in WC (year on year), affects the company’s Free Cash Flow?
- Increase in WC is Positive: it is like an indication that the company wants to keep more liquid assets for its forthcoming operation needs. Hence, this amount is deducted from the reported PAT.
- Increase in WC is negative: it is like an indication that the company wants to keep less liquid assets for its forthcoming operation needs. Hence, this amount gets added into the reported PAT.
5. Capital Expenditure (CAPEX)
Capex is the money which a company has spent to expand & upgrade its asset base. In this process they either buy new assets (expansion), or they enhance the capability of their existing assets (modernization).
CAPEX is also an expense for the company. But the way Capex is reported in financial statements is different from other expenses. Normally, all expenses are reported in company’s P&L A/c as it is booked. But CAPEX cost is booked in a staggered way, as depreciation, throught out the life of the asset.
If one does not have access to the company’s cash flow repot, CAPEX can also be calculated from the numbers published in the balance sheet. We can use the below formula to calculate CAPEX:
6. Debt & Its Effect
In FCFE, we are calculating the free cash flow available exclusively for the shareholders. Hence, the effect of debt is must also be taken into consideration.
When we will calculate FCFE, the effect of debt must be considered. Check here.
What will be the effect of debt for the shareholders? Check the below infographics:
Example: Free Cash Flow Calculation
In this example, we will use an example stock Reliance Industries (RIL) and calculate its free cash flow. First, we will collect the numbers from its financial statement. I’ve used the database of moneycontrol to fetch the data for RIL.
There is a reason why Warren Buffett refers to Free Cash Flow as Owners Income. This is that money which is the real profit for the owners of the company.
After undertaking all necessary expenses required to operate and keep the business competition for the long term, what is left in the hands of the owners is called free cash flow.
But to calculate the intrinsic value of a company, calculating only one year’s free cash flow is not enough. Warren Buffett will study at least the last 10-years financial data to forecast the future cash flows of a company.
I’m sure not many have the time to dig so deep into the financial statement of companies. My stock analysis worksheet can help you. It estimates future cash flows and the intrinsic value of a company based on the last 10-years data.