The excess of operating cash flow over capital expenditure is known generically as free cash flow.
For purposes of valuing a company or its equity securities, an analyst may want to determine and use other cash flow measures, such as free cash flow to the firm (FCFF) or free cash flow to equity (FCFE).
FCFF is the cash flow available to both debt and equity investors after all operating expenses (including income taxes) have been paid and necessary investments in working capital and fixed capital have been made. FCFF can be computed starting with net income as follows:
FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv
where:
- NI = Net income,
- NCC = Non-cash charges (such as depreciation and amortisation),
- Int = Interest expense,
- FCInv = Capital expenditures (fixed capital, such as equipment), and
- WCInv = Working capital expenditures.
The reason for adding back interest is that FCFF is the cash flow available to the suppliers of debt capital as well as equity capital. Conveniently, FCFF can also be computed from cash flow from operating activities as follows
FCFF = CFO + Int(1 – Tax rate) – FCInv.
CFO represents cash flow from operating activities under US GAAP or under IFRS, where the company has included interest paid in operating activities. If interest paid was included in financing activities, then CFO does not have to be adjusted for Int(1 – Tax rate). Under IFRS, if the company has placed interest and dividends received in investing activities, these should be added back to CFO to determine FCFF. Additionally, if dividends paid were subtracted in the operating section, these should be added back in to compute FCFF.
FCFE is the cash flow available to the company’s common stockholders after all operating expenses and borrowing costs (principal and interest) have been paid and necessary investments in working capital and fixed capital have been made. FCFE can be computed as follows:
FCFE = CFO – FCInv + Net borrowing.
When net borrowing is negative, debt repayments exceed receipts of borrowed funds. In this case, FCFE can be expressed as follows:
FCFE = CFO – FCInv – Net debt repayment.
