Cash Flow Measures - Free Cash Flow

Overview

Probably the most common measure of cash flow used in valuation is the free cash flow. This is a measure that attempts to correct for the timing problems of earnings as a measure of cash flow. Free cash flow is the cash that is available in any period after all necessary operating expenses have been paid and all necessary investments in working capital and equipment have been paid. It is calculated as:

• Profit after Taxes - the company's earnings. The steps after adjust for the timing of cash flows.
• Plus Depreciation - is an expense for a building which had been bought earlier. In this case, the building is booked as an asset and its depreciation is matched against sales at a later period. From a free cash flow perspective, the payment for the building has already ocurred in the past. Depreciation does not represent a cash flow today, it is cash flow that has already ocurred.
• Minus Increase in Current Assets - The next step is to adjust for the change in working capital. When a customer buys a product, they can do so on credit. However, GAAP will record the revenue in the period in which the purchase occurs. From a cash flow perspective though, the purchase is not an actual cash flow until the customer pays. Increases in credit to customers are recorded as increases in accounts receivable.
• Plus increase in current liabilities The same issues with current assets can happen with liabilities. That is, the company can pay expenses on credit, which will show up as an expense and deducted from revenues, even though it is not an actual cash flow.
• Minus increase in fixed assets Lastly, increases in fixed assets are subtracted. This is because the increase in the asset represents a purchase today, that will get expensed over time (see depreciation above). As noted above, this represents a cash flow out of the company

Accounting for Financing

The above formula represents the cash flows that are available to the equity shareholders of the firm. As such, it is referred to as the free cash flow to equity. Sometimes modelers will model the free cash flow to the firm, which represents the cash flows to both the firm's equity and debt holders. In this case, we need to also add back after tax interest payments to the firms debt holders.

Looking at cash flow to the firm as a whole, instead of to just equity has a couple of advantages. First, it removes issues surrounding the capital structure of the firm.

Second, some firms will have a negative cash flow to equity. Just as in the case of a firm with zero dividend, this may not mean that the firm has a zero or negative value. However, it complicates the creation of a cash flow forecast that can then be discounted to get a value. In this case, most analysts find it easier to create a total firm value based on free cash flow to the firm, and then to subtract out the value of the outstanding debt.