Understanding Free Cash Flow

Understanding how cash flow is measured and analyzed is an important step for businesses. Business owners should constantly monitor and adjust their operations to increase the chances of becoming and staying cash flow positive.

JP Morgan Chase & Co. (JPM) monitors small business activity and presents some sobering statistics for businesses' cash flow challenges. For a median small business, JPM has found the middle amount of daily cash outflows to be $374 and average daily cash inflows to be $381. The middle statistics for small businesses hold an average daily cash balance of $12,100 and an average of 27 cash buffer days in reserve.

Defining Free Cash Flow to Equity

The Free Cash Flow to Equity (FCFE) calculation measures how much money a company produces that can be dispersed to equity holders. One way to determine this figure is to subtract Capital Expenditures from Cash from Operations and then add Net Debt Issued to the remaining figure.

FCFE = Money from Operations – Capital Expenditures + Net Debt Issued

Interpreting the FCFE's Results

This metric helps businesses, investors, and professional financial experts determine how much money is available for a business' disbursement of dividends and/or share buybacks. The more easily dividends and share buybacks are available via a better FCFE, the better a company is performing financially.

Even though the FCFE can tell how much shareholders may receive, there is no requirement that any of that amount be paid to shareholders. This valuation is preferred for companies that do not pay a dividend. One alternate source of funding buybacks or dividends is through retained earnings from past quarters.

Free Cash Flow to the Firm (FCFF)

Looking at how well a business runs, this calculation examines a company's cash flow health once taxes, investments, depreciation, and working capital are deducted, along with factoring in costs for current and long-term assets. It evaluates how much money the business could disburse to equity and debtholders once the company satisfies its financial obligations.

A company’s FCFF shows how much it has available to issue dividends, buy back shares, or satisfy debt obligations. If the FCFF is negative, there is no consideration for investors, as the business cannot meet existing bills and capital expenditures. When a negative result is found, there is a reason to see if and why there's not enough revenue. Interested parties should consider f it is a short-term need or if the business model needs to be re-tooled.

How FCFF is Calculated

Free cash flow to the firm can be calculated with the following formula:

FCFF = Operating Cash Flow + [Interest Expense √ó (1 – Tax Rate)] – Capital Expenditures

Putting FCFF in Perspective

FCFF must be taken as a part of the holistic analysis, whether it is an investor or the business itself analyzing numbers. If a business is reporting high FCFF figures, an analysis must be taken to ensure long-term investment in business structures, cars/trucks, tooling, and business development are accurately reported. If businesses institute collection protocols sooner than standard, run low inventories or extend satisfying their own financial obligation, it can lower what a business owes and revise its working capital numbers – but that is generally temporary.

With cash flow's impact on a business' operation so integral, understanding how it is calculated is the first step to making smarter operational and investment decisions.

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