Free Cash Flow ( FCF ) Definition
The abbreviation of free cash flow is FCF which is used to measure that grow much more cash generated by the company than that cash which is used to run and expand the business. It can get by subtracting the capital expenditure from operating cash flow.
Free cash flow ratio is considered as an efficiency and liquidity ratio.
In other words, free cash flow is the excess money which generated by the business after paying all the operating expenses and CAPEX of the business. This ratio is very important for analysts because through this analyst know how efficient the company is t generate money and pay the return to the investor after paying all the expenses of the business.
What is Free Cash Flow? FCF Ratio
Through the cash flow ratio ( FCF ) analyst and creditor analyze the business in different ways. Investors also use this measurement to find that how actually the business is doing. In the other financial ratio management can change and adjust the accounting principal but in cash flow ratio it is not possible. Because it is difficult to fack the cash flow coming in and leaving the company or firm. Due to the result’s accuracy of this ratio investors use this ratio to find that the company is able to pay the return on business or not.
Credit also use this ratio to find the cash flow of the company and the ability of the company to meet its current obligation.
Formula of FCF
Free cash formula can be calculated by subtracting the capital expenditure from the operating cash flow. Operating cash flow can be calculated separately by subtract any taxes due and change in net working capital from EBITDA.
Free Cash Flow = Operating Cash Flow – Capital Expenditure
The equation of free cash formula is so simple which calculate how much extra cash company has after the payment of all the cost of fixed asset purchase and taxes.
If the cash is extra then the company can give it to investors but if the cash is in loss then need the loan for the company.
Tom has a tool shop and sold the tools and other household goods. Tom wants to invest in new territory for which he needs new investors. Investor analyzes the cash flow of shop to find the ability of the shop pay return on investment for which investors use the free cash
Income statement of Tom shows that he has 100,000 dollars profit after paying the taxes. For the calculation of net operating cash, we need to add back the noncash expenses like depreciation and amortization. Also, there is a need to adjust the profit for change in working capital. Financial statement of Tom listed below
- Depreciation = $10,000
- Amortization = $5,000
- Current Asset= $100,000
- Current liabilities = $ 80,000
- Fixed Asset Purchase= $50,000
Now operating cash flow ( OCF ) calculated as 100,000 – (100,000 – 80,000) + 10,000 + 5,000= $95,000. This result of OCF by putting in the free cash formula we get the free cash flow of Tom’s shop.
FCF = OCF – Capital Expenditure
$45,000= 95,000 – 50,000
Form the above result it is clear that Tom’s cash flow is greate the total expenditure. So extra money may be used for investment return to the investor or invest back in the business. If the free cash flow is less then the capital expenditure then it is the negative free cash flow and then Tom’s have not enough money to pay its operating expenses of the company.
What is Free Cash Flow Used For?
As free cash ratio is the efficiency and liquidity ratio which analyst used to find the information about the company. High FCF ratio considered best as compare to the low FCF ratio in most cases. Because high FCF indicates that the company easily pay back return on investment to investors after the payment of taxes.
If we observe the free cash flow of above mention shop. Investors analyze that 45,000 dollars are the extra amount which Tom can add back in the investment for the expansion of inventory. From high ratio investors find that it is east risky business for investment.
At every time high free cash flow ratio is not the indication of the well-doing of the company, because if the company cash flow is high but it does not change its equipment. On the breakage of the equipment of the company operations of the company may cease until the equipment replaced.
For more Financial Ratio Check: