Free cash flow

Free cash flow
Source: Tavaga

Free cash flow is the cash flow available to all providers of capital for a venture, after paying for its operating expenses and the fixed and working capital investments. 

Free cash flow lets us value a venture or a company. It is often used in conjunction with a discount rate to arrive at overall cash flow and estimate the intrinsic value of an equity share in the venture. It is essential as it shows the cash flows of the company, and the cash flows of a company are a perfect metric of assessing a company’s performance for the investors.

How to calculate free cash flow?

Free cash flow = Earnings before interest and taxes (1-Tax rate) + Non-cash expenditure (depreciation & amortization) – capital expenditure – Increase in working capital

What is the difference between free cash flow and net income?

Free cash flow takes into account the changes in working capital, the capital expenditure done, and the depreciation is added, whereas in net income changes in working capital and capital expenditure are not accounted for, and depreciation is deducted.

Free cash flows can be of two types:-

  • Free cash flow for the firm — It is the free cash flow that is available to all the providers of capital for the venture. We get the amount by subtracting fixed investments from cash flow from operations
  • Free cash flow for equity — It is the free cash flow that is available to the equity providers, who have a share in the venture in lieu of the cash provided. We get the amount by subtracting fixed investments and payment to debt holders from cash flow from operations.

What is a free cash flow yield?

Free cash flow yield is basically dividing the free cash flow per share by the market price of the stock. It is a financial solvency ratio. Larger companies usually show a higher FCF yield.

Difference between cash flow and free cash flow

Cash flow is calculated by cash flow from operating activity, investing activity, and financing activity. It depicts the solvency of a company, whereas free cash flow is calculated as shown above, and it represents the performance of the company.