In corporate finance, two important numbers help us understand a company’s financial health and value: Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE). These numbers are essential for investors, analysts, and managers because they show how much actual cash a company generates. This cash can be used to grow the business, pay off debt, or give money back to shareholders.
Free Cash Flow to Firm (FCFF)
Free Cash Flow to Firm (FCFF) is a financial metric that measures the cash generated by a company’s operations after accounting for operating expenses, changes in working capital and capital expenditures. It represents the cash available to all of the company’s stakeholders, including both debt and equity holders.
Free cash flows to firm (FCFF) = Cash flows from Operations (CFO) – Capital Expenditure
FCFF = EBIT × (1−Tax Rate) +Depreciation and Amortization − Capital Expenditures− ΔNet Working Capital
Where:
- EBIT: Earnings Before Interest and Taxes (also called Operating Income)
- Tax Rate: Corporate tax rate
- Depreciation and Amortization: Non-cash expenses that account for the reduction in value of assets
- Capital Expenditures: Money spent on buying or maintaining fixed assets like equipment or buildings
- Δ Net Working Capital: Changes in current assets minus current liabilities (an increase in net working capital reduces FCFF, while a decrease increases FCFF)
FCFF gives a clear picture of a company’s ability to generate cash from its core operations, independent of its capital structure (how it’s financed). This makes it useful for evaluating a company’s operational efficiency and potential for growth.
Uses:
- Valuation: Discounted cash flow (DCF) models often use FCFF to determine a company’s intrinsic value (Enterprise Value).
- Comparison: Comparing FCFF across companies helps to assess relative operational efficiency and potential for growth.
- Investment Decisions: Investors use FCFF to gauge the overall financial health and viability of a company for long-term investments.
Free Cash Flow to Equity (FCFE)
FCFE, also known as levered free cash flow, measures the cash flow available to equity shareholders after accounting for operating expenses, capital expenditures, debt repayments, and interest expenses. It represents the cash that can be distributed to equity holders in the form of dividends or share buybacks.
Free cash flow to equity (FCFE) = Free cash flow to firm (FCFF) – Post tax interest cost + Debt taken – Debt repaid + Preference share issuance – Preference Dividend.
or
FCFE = Net Income + Depreciation and Amortization − Capital Expenditures − ΔNet Working Capital + Net Borrowing
- Net Income: Profit after taxes and interest
- Depreciation and Amortization: Non-cash charges
- Capital Expenditures: Investments in fixed assets
- Δ Net Working Capital: Changes in current assets minus current liabilities
- Net Borrowing: New debt issued minus debt repayments
FCFE focuses on the cash flow available to equity investors, providing a clear indication of the company’s ability to generate returns for its shareholders. This metric is essential for understanding the financial health of companies with significant leverage or those that are in the process of reducing debt.
Uses:
- Valuation: FCFE is used in DCF models specifically targeting equity value, often providing a more direct measure of shareholder value.
- Dividend Policy: Companies can use FCFE to determine sustainable dividend payouts and share repurchase programs.
- Investment Analysis: Investors use FCFE to assess the potential for equity returns, especially in companies with varying debt levels.
Key Differences Between FCFF and FCFE
Scope of Cash Flow:
- FCFF considers cash flows available to both debt and equity holders.
- FCFE considers only the cash flows available to equity holders.
Impact of Debt:
- FCFF is unaffected by the company’s financing structure and focuses purely on operational performance.
- FCFE incorporates the impact of net borrowing and interest expenses, reflecting the effects of the company’s leverage.
Valuation Application:
- FCFF is used to value the entire firm (enterprise value), suitable for comparisons across firms with different capital structures.
- FCFE is used to value the equity portion of the firm, focusing on returns to shareholders.
Conclusion
Both FCFF and FCFE are vital tools in financial analysis and valuation, each serving distinct purposes and providing unique insights. FCFF offers a broad view of a company’s cash-generating ability independent of its financial structure, making it useful for overall firm valuation and comparison. On the other hand, FCFE zeroes in on the cash flows available to equity investors, crucial for evaluating potential shareholder returns and making equity investment decisions.
Understanding and accurately calculating these metrics can significantly enhance investment analysis, corporate finance strategies, and overall financial decision-making.