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Concept
Free cash flow
Summary
In financial accounting, free cash flow (FCF) or
free cash flow to firm (FCFF) is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets (known as capital expenditures). It is that portion of cash flow that can be extracted from a company and distributed to creditors and securities holders without causing issues in its operations. As such, it is an indicator of a company's financial flexibility and is of interest to holders of the company's equity, debt, preferred stock and convertible securities, as well as potential lenders and investors.
Free cash flow can be calculated in various ways, depending on audience and available data. A common measure is to take the earnings before interest and taxes, add depreciation and amortization, and then subtract taxes, changes in working capital and capital expenditure. Depending on the audience, a number of refinements and adjustments may also be made to try to eliminate distortions.
Free cash flow may be different from net income, as free cash flow takes into account the purchase of capital goods and changes in working capital.
A common method for calculating free cash flow is shown below:
Note that the first three lines above are calculated on the standard Statement of Cash Flows.
When net profit and tax rate applicable are given, you can also calculate it by taking:
where
Net Capital Expenditure (CAPEX) = Capex - Depreciation & Amortization
Tax Shield = Net Interest Expense X Marginal Tax Rate
When Profit After Tax and Debt/Equity ratio are available:
where d - is the debt/equity ratio. e.g.: For a 3:4 mix it will be 3/7.
Therefore,
There are two differences between net income and free cash flow. The first is the accounting for the purchase of capital goods. Net income deducts depreciation, while the free cash flow measure uses last period's net capital purchases.
The second difference is that the free cash flow measurement makes adjustments for changes in net working capital, where the net income approach does not.
Official source
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