Free Cash Flow

Free cash flow (FCF) is the cash flow that is left over for distribution to the business' owners after all operating and capital expenditure cash needs are satisfied.

There are two variants of free cash flow: the most common free cash flow to firm (FCFF) and the free cash flow to equity (FCFE). The term free cash flow is sometimes used synonymously with free cash flow to firm (FCFF).

Free cash flow (FCF) is a measure closely followed by analysts because it is harder for the management to distort free cash flow as compared to earnings. Further, free cash flow is used in free cash flow model for business valuation.

Formula

The formula used for calculation of free cash flow depends on whether we are starting from net income or from net cash flows from operating activities.

If start from net income, we use the following formula:

Free Cash Flow
= Net Income + Non-Cash Charges − Working Capital Cash Flow Needs
+ Interest × (1 − Tax Rate)
− Cash Flows for Expenditures

Non-cash charges are depreciation, amortization, non-cash provisions, etc. Losses and expenses are added while gains are subtracted (just like in preparing a statement of cash flows)

Positive change in net working capital is subtracted and negative change in net working capital is added.

Capital Expenditure
= Closing net Fixed Assets
+ Depreciation Expense
− Opening Fixed Assets

If we start from cash flows from operating activities, we use the following formula:

Free Cash Flow
= Cash Flows from Operating Activities
+ Interest Expense × (1 − Tax Rate)
− Cash Flows for Expenditures

Example

Microsoft's net cash flows from operating activities for the financial year 2012 amounted to $31,626 million. Interest expense for the period is $380 million and the relevant effective tax rate is 24%. Cash outflows related to additions to property, plant and equipment amounts to $2,305 million. Find Microsoft's free cash flow.

We have the figure for net cash flows from operating activities, so the easiest approach to calculate free cash flow is to start from cash flows from operating activities.

Free Cash Flow = $31,626 million + $380 million × (1 − 24%) − $2,305 million = $29,032 million

Written by Obaidullah Jan