What Is Free Cash Flow to the Firm (FCFF)?

Free cash flow to the firm (FCFF) represents the amount of cash flow from operations available for distribution after accounting for depreciation expenses, taxes, working capital, and investments. FCFF is a measurement of a company's profitability after all expenses and reinvestments. It is one of the many benchmarks used to compare and analyze a firm's financial health.

Key Takeaways

  • Free cash flow to the firm (FCFF) represents the cash flow from operations available for distribution after accounting for depreciation expenses, taxes, working capital, and investments.
  • Free cash flow is arguably the most important financial indicator of a company's stock value.
  • A positive FCFF value indicates that the firm has cash remaining after expenses.
  • A negative value indicates that the firm has not generated enough revenue to cover its costs and investment activities.
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Understanding Free Cash Flow

Understanding Free Cash Flow to the Firm (FCFF)

FCFF represents the cash available to investors after a company pays all its business costs, invests in current assets (e.g., inventory), and invests in long-term assets (e.g., equipment). FCFF includes bondholders and stockholders as beneficiaries when considering the money left over for investors.

The FCFF calculation is an indicator of a company's operations and its performance. FCFF considers all cash inflows in the form of revenues, all cash outflows in the form of ordinary expenses, and all reinvested cash to grow the business. The money left over after conducting all these operations represents a company's FCFF.

Free cash flow is arguably the most important financial indicator of a company's stock value. The value/price of a stock is considered to be the summation of the company's expected future cash flows. However, stocks are not always accurately priced. Understanding a company's FCFF allows investors to test whether a stock is fairly valued. FCFF also represents a company's ability to pay dividends, conduct share repurchases, or pay back debt holders. Any investor looking to invest in a company's corporate bond or public equity should check its FCFF.

A positive FCFF value indicates that the firm has cash remaining after expenses. A negative value indicates that the firm has not generated enough revenue to cover its costs and investment activities. In the latter case, an investor should dig deeper to assess why costs and investment exceed revenues. It could be the result of a specific business purpose, as in high-growth tech companies that take consistent outside investments, or it could be a signal of financial problems.

Calculating Free Cash Flow to the Firm (FCFF)

The calculation for FCFF can take several forms, and it's important to understand each version. The most common equation is the following:

FCFF=NI+NC+(I(1TR))LIIWCwhere:NI=Net聽incomeNC=Non-cash聽chargesI=InterestTR=Tax聽RateLI=Long-term聽InvestmentsIWC=Investments聽in聽Working聽Capital\begin{aligned} &\text{FCFF} = \text{NI} + \text{NC} + ( \text{I} \times ( 1 - \text{TR} ) ) - \text{LI} - \text{IWC} \\ &\textbf{where:} \\ &\text{NI} = \text{Net income} \\ &\text{NC} = \text{Non-cash charges} \\ &\text{I} = \text{Interest} \\ &\text{TR} = \text{Tax Rate} \\ &\text{LI} = \text{Long-term Investments} \\ &\text{IWC} = \text{Investments in Working Capital} \\ \end{aligned}FCFF=NI+NC+(I(1TR))LIIWCwhere:NI=Net聽incomeNC=Non-cash聽chargesI=InterestTR=Tax聽RateLI=Long-term聽InvestmentsIWC=Investments聽in聽Working聽Capital

Free cash flow to the firm can also be calculated using other formulations. Other formulations of the above equation include:

FCFF=CFO+(IE(1TR))CAPEXwhere:CFO=Cash聽flow聽from聽operationsIE=Interest聽ExpenseCAPEX=Capital聽expenditures\begin{aligned} &\text{FCFF} = \text{CFO} + ( \text{IE} \times ( 1 - \text{TR} ) ) - \text{CAPEX} \\ &\textbf{where:} \\ &\text{CFO} = \text{Cash flow from operations} \\ &\text{IE} = \text{Interest Expense} \\ &\text{CAPEX} = \text{Capital expenditures} \\ \end{aligned}FCFF=CFO+(IE(1TR))CAPEXwhere:CFO=Cash聽flow聽from聽operationsIE=Interest聽ExpenseCAPEX=Capital聽expenditures

FCFF=(EBIT(1tr))+D+LI+IWCwhere:EBIT=Earnings聽before聽interest聽and聽taxes\begin{aligned}&\text{FCFF} = ( \text{EBIT} \times ( 1 - \text{tr} ) ) + \text{D} + \text{LI} + \text{IWC} \\&\textbf{where:} \\&\text{EBIT} = \text{Earnings before interest and taxes} \\&\text{D} = \text{Depreciation} \end{aligned}FCFF=(EBIT(1tr))+D+LI+IWCwhere:EBIT=Earnings聽before聽interest聽and聽taxes

FCFF=(EBIT(1TR))DLIIWCwhere:EBIT=Earnings聽before聽interest聽and聽taxesD=Depreciation\begin{aligned} &\text{FCFF} = ( \text{EBIT} \times ( 1 - \text{TR} ) ) - \text{D} - \text{LI} - \text{IWC} \\ &\textbf{where:} \\ &\text{EBIT} = \text{Earnings before interest and taxes} \\ &\text{D} = \text{Depreciation} \\ \end{aligned}FCFF=(EBIT(1TR))DLIIWCwhere:EBIT=Earnings聽before聽interest聽and聽taxesD=Depreciation

FCFF=(EBITDA(1TR))+(DTR)LIFCFF=IWCwhere:EBITDA=Earnings聽before聽interest,聽taxes,聽depreciationand聽amortization\begin{aligned} &\text{FCFF} = ( \text{EBITDA} \times ( 1 - \text{TR} ) ) + ( \text{D} \times \text{TR} ) - \text{LI} \\ &\phantom {\text{FCFF} =} - \text{IWC} \\ &\textbf{where:} \\ &\text{EBITDA} = \text{Earnings before interest, taxes, depreciation} \\ &\text{and amortization} \\ \end{aligned}FCFF=(EBITDA(1TR))+(DTR)LIFCFF=IWCwhere:EBITDA=Earnings聽before聽interest,聽taxes,聽depreciationand聽amortization

Real World Example of Free Cash Flow to the Firm (FCFF)

If we look at Exxon's statement of cash flows, we see that the company had $8.519 billion in聽operating cash flow聽(below, in blue) in 2018. The company also invested in new plant and equipment, purchasing $3.349 billion in assets (in red). The purchase is a capital expenditure (CAPEX) cash outlay. During the same period, Exxon paid $300 million in interest, subject to a 30% tax rate.

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Image by Sabrina Jiang 漏 Investopedia聽2020

FCFF can be calculated using this version of the formula:

FCFF=CFO+(IE(1TR))CAPEX\begin{aligned} &\text{FCFF} = \text{CFO} + ( \text{IE} \times ( 1 - \text{TR} ) ) - \text{CAPEX} \\ \end{aligned}FCFF=CFO+(IE(1TR))CAPEX

In the above example, FCFF would be calculated as follows:

FCFF=$8,519聽Million+($300聽Million(1.30))FCFF=$3,349聽Million=$5.38聽Billion\begin{aligned} \text{FCFF} = &\ \$8,519 \text{ Million} + ( \$300 \text{ Million} \times ( 1 - .30 ) ) - \\ \phantom {\text{FCFF} =} &\ \$3,349 \text{ Million} \\ = &\ \$5.38 \text{ Billion} \\ \end{aligned}FCFF=FCFF==$8,519聽Million+($300聽Million(1.30))$3,349聽Million$5.38聽Billion

The Difference Between Cash Flow and Free Cash Flow to the Firm (FCFF)

Cash flow聽is the net amount of聽cash and cash equivalents聽being transferred into and out of a company.聽Positive cash flow indicates that a company's聽liquid assets are increasing, enabling it to settle debts, reinvest in its business, return money to shareholders, and pay expenses.聽

Cash flow is reported on the聽cash flow statement, which contains three sections detailing activities.聽Those聽three sections are cash flow from operating activities, investing activities, and聽financing activities.

FCFF is the cash flows a company聽produces through its operations after subtracting聽any outlays of cash for investment in聽fixed assets聽like聽property, plant, and equipment and after depreciation expenses, taxes, working capital, and interest are accounted for. In other words, free cash flow to the firm is the cash left over after a company has paid聽its operating expenses聽and聽capital expenditures.

Special Considerations

Although it provides a wealth of valuable information that investors appreciate, FCFF is not infallible. Crafty companies still have leeway when it comes to accounting sleight of hand. Without a regulatory standard for determining FCFF, investors often disagree on exactly which items should and should not be treated as capital expenditures.

Investors must thus keep an eye on companies with high levels of FCFF to see if these companies are under-reporting capital expenditures and聽research and development. Companies can also temporarily boost FCFF by stretching out their payments, tightening payment collection policies, and depleting inventories. These activities diminish current liabilities and changes to working capital, but the impacts are likely to be temporary.