Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail
Investing Answers Building and Protecting Your Wealth through Education Publisher of The Next Banks That Could Fail

Free Cash Flow to the Firm (FCFF)

What it is:

Free cash flow to the firm (FCFF) is the cash available to pay investors after a company pays its costs of doing business, invests in short-term assets like inventory, and invests in long-term assets like property, plants and equipment.

The firm's investors include both bondholders and stockholders.

How it works (Example):

Cash flows into a business when the company sells its product (revenues, aka sales). Cash flows out to pay the costs of doing business: salaries, rent, taxes, etc. Once expenses are paid, whatever is left over can be used to reinvest in the business.

A company must continually invest in itself in order to keep operating. Short-term assets like inventory and receivables (called working capital) get used up and need to be replenished.  Long-term assets like buildings, plants and equipment need to be expanded, repaired and replaced as they get older or as the business grows.

Once the company has paid its bills and reinvested in itself, hopefully it has some money left over. This is the free cash flow to the firm (FCFF), called such because it's available (free) to pay out to the firm's investors.

To calculate free Cash flow to the firm, you can use one of four different formulas. The main differences among them pertain to which income measure you start from and what you then add and subtract to the income measure to end up with FCFF:

FCFF = NI + NCC + Int * ( 1 – T ) – Inv LT – Inv WC

FCFF = CFO + Int * ( 1 – T ) – Inv LT

FCFF = [EBIT * ( 1 – T )] + Dep – Inv LT – Inv WC

FCFF = [EBITDA * ( 1 – T )] + ( Dep * T ) – Inv LT – Inv WC

NI = net income
NCC = non-cash charges
Int = net interest
T = tax rate
Inv LT = investment in long-term assets
Inv WC = investment in working capital
CFO = Cash flow from operations
Dep = depreciation

All of these inputs can be found in the company's financial statements.

Why it Matters:

Free cash flow is one of the most important, if not the most important, concepts in valuing a stock. As you may already know, the price of a stock today is simply a sum of its future cash flows when those cash flows are put in today's dollars.

Technical analysts aside, most investors buy a stock because you they believe the company will pay them back in the future via dividend payments or stock repurchases. A company can only pay you back if it generates more cash than it spends. Hence the importance of calculating free cash flows.

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