How Is Free Cash Flow Defined And Calculated?

cash accounting vs accrual accounting
| Updated on: May 9, 2022

Cash flow is significant in a company. But, free cash flow is a component of accounting that is not to be confused with cash flow. Free cash flow is the cash that is left over after the company has accounted for all its expenditure. Free cash flow or FCF is the cash that remains after cash payments that have been made to maintain operations and assets. Free cash flow is not the same as net income. While net income measures the company's profitability, free cash flow measures the company’s financial health. Some analysts measure the company’s free cash flow to equity separately, differentiating the interest payments from the capital expenditures. The free cash flow is also calculated per share for investors. FCF can accurately determine if the company can expand and pay dividends or if it will need to raise capital soon.

Cash Flow Projection: How to Create a Cash Flow Projection?

What is Cash Flow Statement Definition and Example

What is the importance of free cash flow in accounting?

When studying a company's financial health, the net income is calculated as the revenue less the expenses. The accrual accounting method of calculating the net income ignores the timing of each inflow and outflow. It calculates the simple difference between incoming and outgoing cash for a given period. However, free cash flow excludes many of these revenue and expense accounts. To understand what is free cash flow, we look at the actual flow of cash without considering profit. FCF does not consider non-cash expenses that are otherwise featured on financial reports. FCF tells you how much cash the company has left over after making all payments. It indicates the company’s financial health and performance.

So, if your company shows that it has a positive FCF, it means that after you have paid all your bills and dues at the end of the month, you have excess cash left. If your FCF is on the rise, the company is doing well. A negative cash flow shows no cash left over after paying bills. If you have one excellent month in the middle of an accounting period, the company may look healthy while calculating net income. But the FCF would show that there were cash constraints most months that were overcome in that one good month. So, FCF is significant in accounting to give a more detailed and realistic picture of the company’s cash position.

What is the free cash flow hypothesis?

Theoretically, when there is a positive free cash flow, the company's managers should pay out this excess cash to the company's shareholders. But, Jensen (1988) stated the free cash flow hypothesis that managers who have free cash flow usually invest in negative net present value (NPV) projects instead of paying it to shareholders. This could be because the payout of this money reduces the resources that the managers have in hand. When they need more capital later, they would have to face the formalities involved in a company acquiring new capital. Therefore they may prefer to use these funds by financing new projects rather than paying them out to shareholders.

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

A company’s net earnings or loss is calculated to arrive at the earnings per share (EPS) or the price-to-earnings (P/E) ratios. These calculations include all the noncash expenses such as depreciation, amortization, stock-based employee compensation, and inventory changes. The net income is also calculated for a period by summarizing the period’s inflow and calculating the difference with expenses. Since it is a summary, it gives the overall picture for that period rather than the detailed picture.

On the other hand, free cash flow deals with the cash left after paying the expenses and dues. It only factors the actual cash paid as an expense rather than other calculated expenses such as depreciation and amortization. It gives a clearer and more detailed picture of the company's profitability. By only tracking the cash transactions, it prevents the manipulation of the net income and other financial report calculations by the income generated by the sale of assets. Some companies also manipulate their financial statements by adjusting the value of their inventory products. When a company makes a large purchase, the income statements may not look positive, but the free cash flow statements give a clearer picture. It is also important to distinguish free cash flow from the EBITDA or earnings before interest, tax, depreciation, and amortization. EBITDA is, however, more similar to FCF as it also excludes interest payments on debt and tax payments.

How do you calculate free cash flow from a cash flow statement?

 You can calculate free cash flow simply as

Free cash flow = Net cash from operations - Capital expenditure

These amounts will usually be present on the company’s cash flow statements as part of their annual financial filing. The capital expenditures would differ from company to company. A company may spend on equipment while another may spend on e-commerce marketing.

You can also calculate free cash flow by taking the cash flow from operations and adjusting the interest expenditure and the tax shield. The difference between this number and the capital expenditure is the cash flow.

Item

Statement

Cash Flow From Operations

Cash Flow Statement

Interest Expense

Income Statement

Interest Expense Tax Shield

Income Statement

Capital Expenditure

Cash Flow Statement

The free cash flow formula from the cash flow statement is:

Free Cash Flow = Cash Flow From Operations + Interest Expense - Interest Expense Tax Shield -

Capital Expenditure

How to calculate free cash flow from a company's balance sheet?

If you have a company’s balance sheet details, you can calculate FCF by taking the earnings before interest and taxes (EBIT) and adjusting for income taxes, non-cash expenses, changes in working capital, and capital expenditure.

Item

Statement

Earnings Before Interest X (1- Tax Rate)

Income Statement

Non-Cash Expenses Such As Depreciation Etc

Income Statement

Change In (Current Assets - Current Liabilities)

Balance Sheets Of Current And Previous Period

Capital Expenditure

Balance Sheet

The free cash flow formula from the balance sheet is:

Free Cash Flow = (Earnings Before Interest X (1- Tax Rate)) + Non-Cash Expenses - Change In (Current Assets - Current Liabilities) - Capital Expenditure

Where can we find a free cash flow of companies?

The FCF of a company can be calculated from its financial reports. You can calculate it from the cash flow and income statements by extracting the cash flow from operations and subtracting the capital expenditures. The interest expense and the tax shield for the interest expenses are adjusted. You can also calculate the FCF by looking at the balance sheet for the current and last periods. The company’s earnings before interest (EBIT) are adjusted for taxes, changes in working capital, and non-cash expenses. The capital expenditure is subtracted to arrive at the free cash flow. Though both the calculations will give you the same number, you can choose the calculation based on the financial reports that you have access to. Most of this information will be present in the company's annual filing.

What does a low free cash flow per share mean?

The free cash flow per share is the total FCF divided by the number of shares outstanding. It is a way to determine the change in earnings per share. If a business is doing well, it usually has more cash than required for operations and capital expenditure. So, an increasing free cash flow will increase the free cash flow per share since the numerator increases with a static denominator. A company with a high free cash flow per share can be seen as a company whose business and financial flexibility are rising. Some people also refer to free cash flow per share as free cash flow for/to the firm or FCFF.

The free cash flow formula per share is

Free Cash Flow Per Share = Free Cash Flow / No Of Shares Outstanding

So, if a company has more free cash flow per share, it indicates that it has enough cash for purposes such as paying debt, growing the business, buying back stock or paying dividends to the shareholders. One can also surmise that a company's share prices with high FCF per share will rise, indicating that the earnings per share have also gone up.

A similar term that is not the same as free cash flow per share is Free Cash Flow to Equity (FCFE) which is FCF to the firm without including interest expenses, leaving the free cash flow available to equity shareholders. FCF is only related to the cash flow items and not other expenses such as depreciation.

Investors also look for a company with a high free cash flow as more money available enables the business to expand or pursue new opportunities which enhances shareholder value. More cash will also mean less reliance on debt. FCF is less easy to manipulate than the net income.

A low free cash flow per share could be a positive thing if it is caused by the company making significant investments. A shareholder should study this aspect and judge if those investments yield better results in the longer run. So, a low FCF per share should be taken in the context of the capital expenditure that the company has made.

What is the difference between free cash flow and reserves?

Free cash flow, as explained earlier, is the excess cash that the company has after paying its operating expenses and capital expenditures. It is not the same as reserves. Reserves are funds that a company has set aside expressly for emergency use or unexpected expenses. Reserves are usually set aside for the short term.The cash reserve may be put aside in the company’s bank account or a separate account designated for it. It is often highly liquid and easy to access. The amount of cash that a company must hold in reserve can be up to six months of operational expenses. A company should have enough cash in reserve to tide over any unexpected issues. However, if it is holding too much cash in reserve, it may be losing out on the opportunity to put the cash to better use for expansion or growth.

What does it mean when a firm's free cash flow is negative?

Free cash flow is the cash that is free of any obligations. It is cash that the company can payout to shareholders or use for expansion. A positive or negative FCF should be understood in the right context. A company that has purposefully avoided a capital expenditure may show an artificially high FCF. A company that has made suitable investments and high capital expenditure may have a low FCF.

If the FCF of a company is continually low, it signals a problem. The company would most likely have to raise funds to remain operational. A company with an FCF that is just enough to maintain operations will not be able to expand and be more competitive. So, FCF can determine the future financial health of a company and if it is likely to pay dividends.

Read More:

TallyPrime

Accounting solutions to help you manage your business just the way you want.