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Cash Flow Guide for Beginners – Understand CF, FCF, FCFF, FCFE
“Entrepreneurs believe that profit is what matters most in a new enterprise. But profit is secondary. Cash flow matters most.”
—Peter Drucker
Cash flow is one of the most decisive metrics in the valuation of companies, especially in industries where cash flow is hard to predict or isn’t always positive. In an organization, cash flow is typically a means of evaluating cash available for reinvestments and overall company liquidity.
There are several terms associated with a cash flow that all denote different meanings. So in this guide, we’ll understand the cash flow statement, free cash flow, free cash flow to equity, and free cash flow to the firm.
Cash Flow (CF):
Cash flow means the net inflow and outflow of cash and cash equivalents at the year-end, where cash received is represented as inflow and cash paid as outflow. Cash flow statements are divided into three parts-
Cash flow from operating activities such as sales of finished goods,
Cash flow from investing activities, such as dividends received on investment in other companies,
Cash flow from financing activities, such as the issue of fresh equity.
Positive cash flow means that a company’s liquid assets are growing. It means that it can repay its liabilities, invest in its business, return money to shareholders, pay expenses, and protect itself from future financial problems. Companies with favourable cash flow can take advantage of profitable investments. They also perform better during economic downturns to avoid the consequences of financial distress.
The cash flow statement is a mandatory financial statement released by a company. The cash flow statement is a formal financial statement that shows a company’s sources and usages of cash over a financial year. The stakeholders use cash flow statements to take their financial decisions on whether to invest in such a company.
Cash also includes cash equivalents such as liquid assets, marketable securities, and assets that can be liquified in a very short term.
Free Cash Flow (FCF)
Free cash flow means the cash available for an entity to repay to its creditors, interest to the debt holders, and dividends to the shareholders. It represents the profits after excluding non-cash expenses on the profit-and-loss statement and includes expenses on assets and changes in working capital.
Evaluating free cash flow and understanding helps the firm manage its cash better. It helps in understanding trends of the company’s financial position and operating cycle.
Free cash flow is a significant number because it shows its financials. Investors use free cash flow to figure out if a company has enough money to pay out dividends or buy back its shares.
Learning about the company’s finances through the FCF calculation can help investors make sound investment decisions.
Here’s the formula:
FCF = Cash from operations – capital expenditures (CapEx)
Let’s understand with an example-
|
Particulars
|
Amount
|
|---|---|
|
revenue
|
12,00,000
|
|
Cost of revenue
|
|
|
Operating expenses
|
2,00,000
|
|
Selling expenses
|
50,000
|
|
Interest paid
|
10,000
|
|
Income tax
|
15,000
|
|
Net operating income
|
1,25,000
|
Here are the other details:
- Depreciation – 5,000
- Current assets – 12,000
- Current liabilities – 7,000
- Fixed assets – 2,00,000
- Tax rate is 30%
Calculate- FCF
FCF = Cash from operations – capital expenditures (CapEx)
FCF = 1,25,000 – [(12,000-7,000) + (5,000+2,00,000)]
FCF = -85,000
To determine the company’s expected performance, investors need to use other variations of free cash flow, as interest payments are excluded from the definition of free cash flow.
There are two variations available that have already been adjusted for interest payments and borrowings:
- Free cash flow to the firm
- Free cash flow of the equity
Free Cash Flow to Firm (FCFF)
FCFF is a measure of a company’s ability to pay dividends or interests, buy back shares, or repay debt. Any person who wants to invest in a company’s corporate bond or stocks should look at its FCFF.
After the company pays all its operating costs and investments in working capital and long-term assets, the cash left is called “FCFF,” or “Free Cash Flow”. FCFF is the money available for its bondholders and stockholders.
The FCFF formula is a measurement of a company’s operations and performance. FCFF looks at all cash inflow, all-cash outflow, and all cash reinvestments in the business to grow. Cash available after above mentions deductions is known as a free cash flow to the firm.
Free Cash Flow to Firm (FCFF) is also a critical indicator of a company’s stock value. When people talk about the value or price of a stock, we determine its expected future cash flows. Investors can evaluate the fair price of the company’s stock by FCFF.
- A positive FCFF value means that the company has the cash left for its shareholders and bondholders.
- Negative FCFF values show that the company does not have cash for distribution.
The formula for determining Free Cash Flow to the firm:
FCFF= Net Income + Depreciation and amortization + Interest (1-tax rate) – working capital investments – capital expenditure
Let’s understand by referring to the same example as above-
= 1,25,000 + 5,000 + 10,000(1-.30) – (12,000-7,000) – (5,000+2,00,000)
= -73,000
Free Cash Flow to Equity (FCFE)
Free cash flow to equity measures how much money is available to a company’s equity shareholders after excluding operating expenses, debt repayments, interest payments, and reinvestments.
There are four parts to free cash flow to equity:
- Net Income,
- Capital Expenditures,
- Working Capital, and
- Debt.
How to find out four elements of FCFE
Net Income
Net income can be taken over from the income statement of the relevant financial year.
Capital expenditures
Capital expenditure can be determined by cash flow from investing activities of the cash flow statements.
Working capital
The company’s working capital can be determined by changes in working capital statements or cash flow from operating activities of the cash flow statements. The basic formula for determining working capital is:
Working Capital = Current Assets – Current Liabilities
Debt
The balance sheet of the company shows the total amount of the debt.
Cash available for the shareholder is not equal to cash paid to the shareholders.
Analysts use the FCFE number to evaluate a company’s net worth. FCFE may figure out how much money is available to shareholders, but that doesn’t always mean how much they paid out to shareholders. Only a part of distributable profits is paid as dividends. Companies reinvest the rest of the amount in the business for expansion.
The formula of calculating Free Cash Flow to the equity-
FCFE = Cash from operations − CapEx + Net debt issued
Let’s understand by referring to the above example:
Assuming net debt issued of the company is 1,50,000 and all other information is same, FCFE is-
= 1,25,000 – [(12,000-7,000) + (5,000+2,00,000)] + 1,50,000
= 65,000
Conclusion:
By analyzing the above-detailed discussions over various diversified ways of measurement, we conclude that cash flow is a part of current assets and an essential dimension to judge a company’s financial position. Cash flow formulae are a helpful tool for making financial decisions for investors and management.
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