Free Cash Flow: How To Calculate FCF From Financial Statements [Calculator]

What is Free Cash Flow? We will understand FCF with an example. DCF valuation model uses FCF to estimate intrinsic value...

Free Cash Flow (FCF) is an improved version of net profit (PAT). What is easily available in company’s financial statement is PAT. But FCF must be separately calculated by the investors. 

Warren Buffett mentions Free Cash Flow as “Owners Income”. It was Buffett who made the use of Free Cash Flow popular for stock analysis.

What is the use of Free Cash Flow? FCF is used to calculate intrinsic value of a company. The method used to estimate the intrinsic value of stocks is done by using a financial model called Discounted Cash Flow (DCF)

In the calculation of intrinsic value, correct estimation of free cash flow is essential. Accurate will be the free cash flow estimation, precise will be the intrinsic value calculation.

In this article we will learn about how to estimate free cash flow of a company. 

Why to estimate free cash flow?

There are cases where the company has reported a positive PAT but upon calculation its FCF came negative. Negative FCF means, its intrinsic value is zero. Let’s see how FCF is derived out of PAT…

Free Cash Flow - Flow Chart

In intrinsic value calculation, experts prefer the use of Free Cash Flow instead of PAT. Why? Because free cash flow is the real representation of actual profit of the owners.

Who are the owners of a publicly traded company? It is the shareholders. It means, if you and me want to value a stock, we must know its FCF (PAT will not work).  

The above flow chart will represent the difference between Net Profit (PAT) and Free Cash Flow. In terms of formula, difference between PAT and Free Cash Flow looks like this:

Free Cash Flow - Formula

Allow me to explain each of the ingredients of the Free Cash Flow formula. It will help us to see FCF in its right perspective:

1. Net Profit (PAT)

It is that income which the company has generated after adjusting all expenses. These expenses includes the mandatory depreciation and amortisation, interest and income tax payment.

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 profitably, there are few strategic expenses that must be accounted.

Adjustment of all these strategic expenses gives the REAL net profit (called free cash flow or owners earnings).

Here we will discuss more about these strategic expenses (prepayment of debt, funding Capex, and funding increase in working capital).

2. Debt Prepayment

Free Cash Flow - Debt Repayment

Companies take debt to fund its operations and Capital Expenditure (CAPEX) Plans.

It is in the interest of the company to keep their long term debts within the acceptable limits. Business experts often rate debt free companies highly.

Hence, the first logical use of PAT shall be for lowering the debt levels (if necessary).

How to know if a company should consider debt repayment? The same can be judged by looking at their Debt to Equity ratio and Interest Coverage Ratio.

3. Depreciation & Amortisation (D&A):

Free Cash Flow - D&A

This is a non-cash expense reported in company’s income statement. They are not real expenses but a mandatory accounting adjustment as per GAAP.

It can also be understood as an adjustment done in company’s asset line to incorporate for loss in value of a fixed asset (like machinery etc) with time.

As this is a non-cash expense, hence in estimation of free cash flow, we can add this expense back to PAT. It then represents the real capital (cash) available with the company for onward use.

4. Change in Working Capital

Free Cash Flow - Change in WC

Let’s first know about the components of working capital’s formula.

  • 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), cash 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 year 2020. Suppose a hypothetical company ABC reported $100Mn in current asset (CA) in FY2019. The company also reported an immediate obligation of $75Mn in current liability (CL).

It means, out of the available $100Mn, $75Mn is already booked to handle current liabilities for the past year 2019. Hence, what is available for year 2020 is only $25Mn.

WC ($25Mn) = CA ($100Mn) – CL ($75Mn)

This $25Mn is what we call as working capital. This is the net available fund generated by the company’s operations in year 2019, that can be used to fund the operational needs in year 2020.

Suppose there is another hypothetical company XYZ which reported $120Mn in current asset (CA) in FY2019, and $130Mn in current liability (CL). As CL is more that CA, hence its working capital will be in negative.

WC (-$10Mn) = CA ($120Mn) – CL ($130Mn)

A 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 current liability deficit for 2019, and to meet the forthcoming current liabilities requirement for 2020.

How change in WC (year on year), effects the company’s Free Cash Flow?

  • When change in WC is positive: it is 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.
  • When change in WC is negative: it is 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. New Debt

Free Cash Flow - New Debt

To keep the business running, a company might resort to new debt. How a company will know if it needs new debt? By looking at its current and long term capital needs.

Current needs can be judged by looking at their current liability and current asset forecasts. If there is an increase in working capital between last year and current year, then the enhanced requirement must be compensated from PAT.

If these needs are large, which cannot be taken care by company’s net profit (PAT), company will resort to new debt to make up for the deficit.

A company which is making enough net profit, and is also collecting cash fast enough from its customers, may not need new debt to fund its Operations and Capex.

6. Capital Expenditure (CAPEX)

FCF - CAPEX

Capex is the money which a company must spend to build & upgrade its asset base. In this process they either buy new assets for the company, or they enhance the capability of their existing assets.

Buying new asset is a part of their expansion plan. Enhancement of existing asset is a part of their modernisation plan. Expansion and modernisation is done by taking up new in-house projects.

Capital Expenditure (CAPEX) is also an expense for the company. But the way Capex is reported in financial statements is different from other expenses. Normally, expenses are reported in company’s Profit & Loss A/c. But Capex is reported in company’s cash flow statement.

If CAPEX value is not reported in cash flow report, an approximate CAPEX can also be calculated from the numbers published in P&L A/c and Balance Sheet. We can use the below formula to calculate CAPEX:

Free Cash Flow - Capex Formula

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.

Free Cash Flow - RIL Calculation Example

Access free online FCF Calculator here

Conclusion

There is a reason why Warren Buffett refers 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 competitive for long term, what is left in the hands of the owners is called free cash flow.

But to calculate intrinsic value of a company, calculating only one year’s free cash flow is not enough. Warren Buffett will study at least last 10 years financial data to forecast future cash flows of a company.

I’m sure not many has 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 intrinsic value of a company based on last 10 years data.

Just copy paste the data from internet into the worksheet, and rest is done automatically by it. Give it a try

16 Comments

  1. I looked at HUL’s annual report, but I didn’t found any short term or long term borrowing there was only borrowing. Then how will I calculate the LT debt and ST debt?

  2. Hi,
    For FCF working you have given the formaulae (the example of reliance). Instead of doing this working,can’t we obtained the FCF from Cash Flow Statement in financials ?

    • There can be two reasons. First, the algorithm of the worksheet is more detailed. Second reason is FY range (Mar’20, Mar’19 ….)

  3. In BELOW FREE CASH FLOW FORMULA
    (F+N+G1)-(I+K)
    in this formula G1(depreciation) is on both side as G1(dipreciation) is also added in “I”(capex).
    Then what is use of adding G1(depreciation) and then supstracting it again in I(Capex)

  4. Great work ,Every thing is explained with detail,
    But there is an issue-
    In free cash flow calculation,while calculating new short term borrowings of current year,current year short term borrowings is subtracted by previous year short term short term borrowings,you use a formula
    M=E1-E2. But previous year short term borrowings has be paid within next 12 months,that means before releasing current year balance sheet. Now,the short term borrowings mentioned in current year balance sheet is borrowed only in current year, so why you said to subtract current year short term borrowing by previous one…

    • We cannot assume it like this. Suppose FY is ending in March’20. A short term loan was taken in say January’20. The validity of this loan is 12 months. Hence, in most cases the loan will not be paid by March’20. Hence it is better to take the cumulative loan numbers for estimation.

  5. Hi Mani, Do you have compiled list/page of india’s top free cash flow generating companies ?
    Is there any link you can point me to ? internal/external.

    It would be nice to have one list on site. just a thought.

    keep up the good work. I really enjoy reading.

    • Thanks for the idea. I’ll try to post this data in this blog itself. Give me some time. Thanks again.

  6. Hi Mani,

    Since I am a mac user. I am facing problems in using your stock analysis worksheet. Would be super helpful if it can be provided as compatible with “Google sheets” too. Let me know if that’s possible. Thanks.

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