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Free Cash Flow Definition

See also:
Discounted Cash Flow Analysis
Valuation Methods
Free Cash Flow Analysis

Free Cash Flow Definition

The business is like a human body, the body needs blood, the business needs cash. Investor look at Free Cash Flow to make their decision for investment. Interestingly, it’s not a number you can come up easily. First, let’s look at the free cash flow definition. Many business owners, somehow, are not familiar with Free Cash Flow. The Free Cash Flow definition is cash generated by the company after deducting capital expenditures from its operating cash flow the amount of. In other words, after the company pays for employees, debts, expense, fixed assets, rent, plant, etc., whatever money you have got left (“left-over money“) is called Free Cash Flow.

FCF Example

For example, a company has $1 million cash flow from operating activities in its financial statement. However, they are spending more than $900,000 on purchasing property plants or replacing equipment. In this case, the investor will have to analyze the business to see if it was either a poor management decision or a high growth opportunity (i.e. more investment than cash on hand).

Even when a company makes positive Net Earnings, it doesn’t necessarily mean that company has Free Cash Flow.


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Why is Free Cash Flow Important?

As it mentioned above, cash keeps the business running. If your company has Free Cash Flow, then what should the company be spending the money on? They could either hire more employees, invest in other assets, issue dividends, or make more acquisition. Before you make the decision, there are 3 main reasons you would consider FCF as a competitive advantage to maintain the business growth rate.

Free Cash Flow to Equity (FCFE)

FCFE measures the Equity value, referred as “levered” cash flow. It’s the amount of money available for equity shareholders after paying all expenses, debts, reinvestment. Also, consider free cash flow to equity as an adjustment for debt cash flow.

Free Cash Flow to Firm (FCFF)

FCFF measures the enterprise value, referred to as “unlevered” cash flow. Free cash flow to firm shows available cash to all investor – both debt and equity. In an Unlevered Discounted Cash Flow analysis, you would use WACC (Weighted Average Cost of Capital).

Valuation using Free Cash Flow

Other than using DCF method (Discounted Cash Flow), use Free Cash Flow to estimate the present value of a business.

FCF = Present Value.

By calculating free cash flow, you can interpret discretionary cash flow of the company. If FCF is positive, then the company has many options where to put the money in. Whereas if FCF is negative, then you have to analyze if it’s a one-time issue or a recurring problem. If it’s constantly negative, then the company has to raise more money (debt or equity) or eventually has to restructure itself.

Free Cash Flow Formula

The free cash flow formula is very simple. Look at the Cash Flow Statement. Subtract Capital Expenditures from Operating Cash Flow.

Free Cash Flow = Cash Flow from Operation – Capital Expenditures

Operating Cash Flow

Operating cash flow is the amount of money required to fund a company’s normal operation. It’s usually in bold and always show before Financing and Investing Cash Flow. You can also refer to Operating Cash Flow as “Working Capital“.

 Capital Expenditures (CAPEX)

Find Capital Expenditures (CAPEX) in the Cash Flow Statement, under Cash Flow from Investing Activities. However, Capital Expenditures is sometimes listed as Purchase of Property & Equipment. Capital Expenditure is different from Operating Expense (OpEx).

If you want to increase cash flow, then click here to access our 25 Ways to Improve Cash Flow whitepaper.

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Outstanding Debt

See Also:
Collateralized Debt Obligations
Convertible Debt Instrument
Debt Ratio Analysis
Debt Service Coverage Ratio (DSCR)
Overhead Rate
Imprest Account

Outstanding Debt Definition

Outstanding debt, defined as the total principal as well as interest amount of a debt that has yet to be paid, is of core importance for any company which has used debt financing. It is important because it expresses a dollar amount to be paid before a liability is closed.

Outstanding Debt Explanation

With a little work, an outstanding debt letter can also be used to represent an amount of time until a liability is closed. Outstanding debt is of pivotal importance to a company because it represents an important point: once this debt is closed a company has additional freedom to receive more free cash flow, take out other loans, and ultimately receive greater profits.

This type of debt can indicate either short term (1 year) or long term (greater than 1 year) debt. Any debt that has yet to be fully paid has an amount of outstanding debt, whether it is 1 cent or $1,000,000. For outstanding debt, collection is not a factor because this term does not indicate debt which is past due.

Outstanding Debt Example

Brewco is a company which manufactures beer. Brewco, a maker of premium quality beers, is a company with growing demand for products. Pubs and consumers alike are becoming interested in the new brands of beer which Brewco invents on a regular basis.

Brewco is experiencing so much growth, in fact, that it needs to take another loan. The problem with this is that Brewco already has outstanding debt for a loan the company took in the startup phase. Brewco is in a difficult position because it needs new capital but will not qualify for a loan until it has repaid the outstanding debt which it is responsible for. The company has $100,000 of outstanding debt. In comparison, Brewco is just experiencing the first taste of success and only projects $20,000 of free cash flow this year.

Penny, a beer afficianado and the founder of Brewco, knows exactly what she must do. After trying to find financing from a variety of sources she decides to use her own savings to pay down the loan. Penny knows that she is taking a risk here: the company may experience less demand in the future than it does now. Still, Penny believes in her product and company. Additionally, Penny can afford to loose some of her savings to this risk. She has a satisfactory amount from her previous work for a major brewing company.

Conclusion

Penny moves forward to this risk with confidence. She always knew the success of her company was up to her. Penny prepares for the future as she works on the present.

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Outstanding Debt
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Adjusted Present Value (APV) Method of Valuation

See Also:
Valuation Methods
Net Present Value Method
Internal Rate of Return Method
NPV vs IRR
Capitalization

Adjusted Present Value (APV) Method of Valuation Definition

Adjusted Present Value (APV) Method of Valuation is the net present value of a project if financed solely by equity (present value of un-leveraged cash flows) plus the present value of all the benefits of financing. Use this method for a highly leveraged project.

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Adjusted Present Value Method Calculation

1. Calculate the value of un-leveraged project by discounting the expected free cash flow to the firm at the un-leveraged cost of equity.

2. Then, calculate the expected tax benefit from a given level of debt by discounting the expected tax saving at the cost of debt to reflect the riskiness of this cash flow.

3. Finally, evaluate the effect of a given level of debt on the default risk of a company and expected bankruptcy costs.

Thus, the APV calculation is as follows:

Value of the operating assets = Un-levered firm value + PV of tax benefits – Expected Bankruptcy Costs

Adjusted present value = value of the operating assets + value of cash and marketable securities.

Adjusted Present Value Application

APV method is very similar to traditional discounted cash flow (DCF) model. However, instead of weighted average cost of capital(WACC), cash flows would be discounted at the cost of assets, and tax shields at the cost of debt. Technically, an APV valuation model combined impact of both growth and the tax shield of debt on the cost of capital, the cost of equity, and systematic risk. Thus it is a more flexible way of approaching valuation than other method. However, APV method has some flaws. Company value will be overstated when adding the tax benefits to un-levered company value to get the levered company value, especially for some companies with high debt ratios.

Take some time to read over our Top 10 Destroyers of Value whitepaper before you start your company’s valuation.

Adjusted Present Value (APV) Method of Valuation

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Free Cash Flow Analysis

See Also:
Cash Flow Projections
Discounted Cash Flow Analysis
Cash Cycle
Steps to Track Money In and Out of a Company

Free Cash Flow Analysis Definition

Free cash flow analysis is the amount of cash that a company can put aside after it has paid all of its expenses at the end of an accounting period.

Calculation of Free Cash Flow

Free cash flow = Net cash flow from operating activities – capital expendituresdividends

Or

= Net income + amortization + depreciation + deferred taxes – capital expenditures – dividends


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Applications

Free cash flow is an important measurement of the unconstrained cash flow of the company. It measures a company’s ability to generate internal growth and to return profits to shareholders.

Positive free cash flow means that a company has done a good job of managing its cash. If free cash flow is negative then the company may have to look for other sources of funding such as issuing additional shares or debt financing.

Negative free cash flow is not necessarily an indication of a bad company, however, since many young companies put a lot of their cash into investments, which diminishes their free cash flow. But if a company is spending so much cash, it should have a good reason for doing so and it should be earning a sufficiently high rate of return on its investments.

The CEO's Guide to Improving Cash Flow


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Discounted Cash Flow Analysis

See Also:
EBITDA Definition
Steps to Track Money In and Out of a Company
Arbitrage Pricing Theory
Discount Rate
Required Rate of Return
(Discount Payback period) DPP

Discounted Cash Flow Analysis Definition

The definition of a discounted cash flow (DCF) is a valuation method used to value an investment opportunity. Discounted cash flow analysis tells investors how much a company is worth today based on all of the cash that company could make available to investors in the future. It requires calculation of a company’s free cash flows (FCF) in addition to the net present value (NPV) of these FCFs. There are three major concepts in DCF model: net present value, discounted rate and free cash flow. Estimate all future cash flows and discount them for a present value. Generally, use the discount rate as the appropriate cost of capital. It also incorporates judgments of the uncertainty of the future cash flows.


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Discounted Cash Flow Analysis Formula & Example

Use the following formula to calculate Equity Value:

Equity value = ∑Annual free cash flow to equity/(1 + cost of equity)^t + residual value/(1 + cost of equity)^t

Use the following formula to calculate Enterprise Value:

Enterprise value = ∑Annual free cash flow to firm/(1 + cost of capital)^t + residual value/(1 + cost of capital)^t

Or use constant-growth free cash flow valuation model when free cash flow grows at a constant rate g. The free cash flow in any period is equal to free cash flow in the previous period multiplied by (1+g).

Equity value = Annual free cash flow to equity * ( 1+ g)/(cost of equity – g)

Enterprise value = Annual free cash flow to firm * ( 1+ g)/(cost of capital – g)

Free cash flow to equity is the cash flow available to the company’s common equity holders after all operating expenses, interests, and principal payments have been paid. Necessary investments in working and fixed capital have also been made. It is the cash flow from operations minus capital expenditures minus payments to debt-holders.

Free cash flow to firm is the cash flow available to the company’s suppliers of capital after all operating expenses (including taxes) have been paid and necessary investments in working capital and fixed capital have been made. It is the cash flow from operations minus capital expenditures.

For example, a company is projected to have fluctuating cash flows. Losses of $10,000 in the first two years, a gain of $20,000 in year 3, $45,000 in year 4 and $ 55,000 in the year 5… How much is it worth today?

Discount the cash flows at a rate acceptable to the investor – 18%.

Time                 Year 1   Year 2   Year 3   Year 4   Year 5   NPV
Projected future cash flow       -10,000  -10,000  20,000   45,000   55,000
Residual value                                                        5,000
Projected annual free cash flow  -10,000  -10,000  20,000   45,000   60,000
Discounted cash flows            - 8,475  -7,182   12,173   23,211   26,227   45,953

This leaves a present value of $45,953. In conclusion, it indicates the estimated fair market value of the company today.

Discounted Cash Flow Analysis Applications

DCF valuation method used to estimate the attractiveness of an investment opportunity. Its analysis uses future free cash flow projections and discounts them to arrive at a present value, which is used to evaluate the potential for investment. If the value arrived at through DCF analysis is higher than the current cost of the investment, then the opportunity may be a good one.

Although DCF is good for investors to do a reality check, it does have shortcomings. DCF analysis is based on its input assumptions. For example, small changes in inputs (such as free cash flow forecasts, discount rates and perpetuity growth rates) can result in large changes in the value of a company. Investors must constantly second-guess valuations. This is because the inputs that produce these valuations are always changing and susceptible to error.

If you want tips on how to improve cash flow, then click here to access our 25 Ways to Improve Cash Flow whitepaper.

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Adjusted Present Value Example

See Also:
Adjusted Present Value (APV)

Adjusted Present Value Example

Joey owns a small chemical plant called Chemco. Chemco, despite the effects of the recent recession, is doing fine. They are doing so well, in fact, that they have excess cash. Chemco decides to look for a suitable investment for the free cash flow of the company.

The next day Joey attends his trade organization meeting. At this meeting he meets the CEO of Chemicalventures, his main competitor to Chemco. They resolve to set aside their differences and meet for lunch. At this lunch meeting, Joey finds out that Billy has decided to sell Chemicalvenutres and wonders if Chemco would be interested in purchasing Chemicalventures. Billy assures Joey that the investment will be worth his time and effort.

Joey, the next day, contacts his board of directors. The board of directors of Chemco is interested in the idea as long as it is financed with debt. First, however, they require the financials of the company as well as the adjusted present value of the deal.

Joey talks to Billy, who sends the company financials over to Joey. Joey begins his preliminary research by Googling “adjusted present value calculator”. Unsatisfied with what he sees, Joey sends the Chemicalventures financials over to his top financial analyst.

Adjusted Present Value Calculation

The analyst performs this calculation based on the Chemicalventures financials:

If…

Investment = $500,000

Cash flow from equity = $25,000

Cost of equity = 20%

Cost of Debt = 7%

Interest on debt = 7%

Tax = 35%

And the deal is financed half with equity and half with debt.

Then…

NPV = -$500,000 + ($25,000 / 20%) = -$375,000 PV = (35% x $250,000 x 7%) / 7% = $87,500

-$375,000 + $87,500 = -$287,500 –> Bad Deal

Joey is pleased to find these results because they have saved him from making a poor business decision. He contacts Billy to tell him that, unfortunately, Chemco can not purchase Chemicalventures.

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Acquisition Capital

See Also:
Capital Structure Management
Capital Expenditures
Working Capital
Cost of Capital
Business Plan

Acquisition Capital Definition

When a business decides to grow, you need acquisition capital. Define acquisition capital as the capital used to acquire other assets. You use this capital to purchase assets like equipment, inventory, software, or even a business itself. The purpose of these acquisitions are, ultimately, to grow the overall profits of a business. As such, the process of acquisition financing requires an ability in strategic analysis of the asset to be acquired, as well as the various financing options. Acquisition capital is used in one of two situations: when the growing business does not itself have the cash to grow or when the growing business will experience greater firm value from financing the purchase as opposed to paying out of the free cash flow of the company.


As you are expanding your company, it’s important to protect your company from “destroyers.”

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Acquisition Capital Explanation

Explained often as the fuel for company growth, acquisition capital is in many cases an industry of it’s own. This is due to the fact that so many companies desire to grow using existing methods and assets rather than creating new campaigns for marketing or cost management. Acquisition capital comes from two main sources: debt or equity financing. Because of this it is not exclusive to one type of firm; companies can provide only acquisition capital, only one type of acquisition capital, or provide other types of capital for operations. Additionally, many types of capital can be used for this, including factoring or personal finances. This makes the term acquisition capital as much an industry term as it is a simple label used to describe money shortly before it changes hands in a purchase.

Acquisition Capital Debt

One of the two main forms of acquisition capital is debt financing. Many describe debt financing more commonly as a loan. When someone is paid back, usually with interest, in the form of loan payments rather than dividend payments one can be sure that debt financing is being used. In this way, an acquisition loan works the same as any other loan.

You can find acquisition capital, in the form of debt, through a variety of sources. First, one could simply access friends and family who can spare the money needed for the loan. We suggest that a business person do this under a specific agreement. Unfulfilled business agreement have damaged many close relationships.

Funding

Next, funding can come in the form of a bank loan. This will, for anyone who does not have access to a wealthy personal contact, almost always be the cheapest form of capital. One can access better interest rates, often, through government lending programs like the Small Business Association (SBA) or Patriot Express loans.

Often thought, mezzanine debt providers act as the middle ground between debt and equity financing. Here, one can receive a loan without collateral. Additionally, the loan contract also allows conversion of the debt to company common stock. Mezzanine debt, however, bears a higher interest rate due to the riskiness of the investment. It is usually provided by venture capital firms or private equity funds.

Asset based lending is another option for financing for acquisition. With an asset based lender, company uses their assets as collateral to back loans. The major disadvantage with this method is that using assets for collateral means that when loan agreements are not met, the assets are seized by the lending party. Logically, if the assets of a growing business are taken it is considerably more difficult to continue growth, if not all operations.

Acquisition Capital Equity

Equity financing is another form of acquisition capital. Rather than receiving a loan which must be paid back, a company which receives equity financing provides company stock, either common or preferred, for the capital it receives. Equity financing is, essentially, payment in exchange for partial ownership in a company. Private equity and venture capital firms, the common providers of equity capital, will receive payback for their investment in one of 2 ways: company cash disbursements in the form of dividends or profit from the final sale of the company which includes their ownership stake. This means, often times, that equity financiers will take greater involvement in the company they have invested in.


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Acquisition Capital Example

For example, Eddy has started and grown a successful restaurant chain. Fighting the odds, he has grown his company from a single small shop to several locations. Using the recipes his grandmother once cooked, Eddy brings delicious food to the city while protecting his trade secrets. Recently, demand for his food has outpaced his ability to produce it. Eddy is now considering acquiring restaurants which serve French food, the cuisine that has risen him to success. Despite this goal, Eddy does not currently have the money to finance his own growth and will need acquisition capital to continue growing his business.

First, Eddy evaluates receiving a bank loan. He meets with a banker, an old high school friend, to discuss options for funding. Sadly, he discovers that he does not have the assets necessary to receive the standard bank loan. The bank will need to see, beyond Eddy’s dream, operations which Eddy has not yet achieved.

Eddy does research on Mezzanine and asset based lending. Here, he finds that he also does not qualify. For mezzanine, Eddy can not afford the interest rates required by lenders. For asset backed lending, Eddy does not have the proper set of company assets to convince the lender that he is worth their risk. Even if he did, Eddy does not see much benefit in promising away his tools for success.

Equity Financing

Eddy then evaluates equity financing. He looks at local and national private equity firms. Here, he finds experience requirements which he does not meet. Additionally, these firms will want increased control over Eddy’s business operations. Eddy is concerned that this might take away from his home-style cooking which has gained attention near his brick-and-mortar locations.

As Eddy is evaluating equity financing, he attends a family reunion. Here, he sees his uncle Ted for the first time in a while. An experienced restauranteur in his own right, Ted has also created a successful restaurant chain which serves Cajun food. Eddy has a very pleasant conversation with Ted and eventually expresses his needs. Ted, wealthy from his success, offers the idea that he could finance the budding series of French kitchens. They discuss the concerns of becoming business partners connected by blood relations. Though this is worry some, the two driven entrepreneurs resolve to continue the conversation later in the week.

Eddy looks forward to talking with Ted. By accessing friends and family, usually the cheapest and easiest of all forms of financing, he may be able to provide success for more than just himself. Additionally, Ted’s experience makes him a wealth of knowledge on acquisition; best practices are key to creating the standards that customers expect. Eddy makes a mental plan of what he will need to prepare in order to convince his uncle that he is worth an acquisition funding.

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