Free Cash Flow—Knowing the Basics

Figure 1. 3 Parts of a Cash Flow (CF) statement

Based on @MnkeDaniel, a Cash Flow (CF) Statement is divided into three parts:^[3]

1. CF from Operating Activities
2. CF from Investing Activities
3. CF from Financing Activities

Figure 2. Free cashflow to equity vs. free cashflow to the firm

Free Cash Flow (FCF)

Professor Aswath Damodaran believes that Free Cash Flow (FCF) is one of the most dangerous terms in finance. In [1], he tries to clarify what free cash flows are trying to measure, how they get used in investing and valuation, and the measurement questions that can cause measurement divergences.

Professor believes that any measurement of free cash flow has to begin with a definition of to whom those cash flows accrue:^[1]

Since a business can raise capital from owners (equity) and lenders (debt), the free cash flows that you compute can be to just the equity investors in the business, in which case it is free cash flow to equity, or to all capital providers in the business, as free cash flow to the firm.

In short,

• FCFE (Free Cash Flow to Equity)
• Is the cash flow that a business generates after taxes, reinvestment and debt payments (interest and principal).
• FCFF (Free Cash Flow to the Firm)
• Is a pre-debt cash flow, before interest payments and debt repayments or issuances, but still after taxes and reinvestment.
• Alternatively, is that it measures the cash flows that would have been available for equity investors, if there were no debt in the firm, and it is for this reason that some call it an unlevered cash flow.

Using Free Cash Flow

Computing free cash flows for a past period, they can used in 3 contexts:^[1]

1. Can help in explaining what happened at a business during that period, in operating, investing and financing terms
2. Can be used as the basis for forecasting expected free cash flows in the future, a key ingredient if you are doing intrinsic valuation
3. Can be used to compare pricing across companies, where the market price is scaled to free cash flow, rather than to earnings

Figure 3. Cash Flow Statement of TSM (Courtesy of schwab.com)

Importance of a Balance Sheet

A balance sheet can tell you whether your business is stable and financially healthy or not:^[4]

• Is there cash
• Can you pay your bills
• How much debt do you have
• What is the book value of the business

@IAmClintMurphy in [4] had listed top to bottom in order of liquidity, which is how fast they can be converted to cash in a firm:

1. Cash
2. Inventory—goods available for sale
3. Accounts receivable—what people owe you
4. Fixed assets—land, machinery, equipment, and buildings

Clint Murphy also covers the topic of liquidity ratios which show a firm's ability to turn assets into cash and include:

• Cash ratio
• Measures your total cash and cash equivalents against your total liabilities
• Is an indicator of your value under a worst case scenario, such as a bankruptcy or business shutdown
• Quick ratio
• Measures a firm's ability to meet its short-term obligations with its most liquid assets - also called the acid test ratio
• A higher ratio = better liquidity and financial health
• Current ratio
• Measures a firm's ability to pay short-term obligations or those due within one year, sometimes called the working capital ratio
• A ratio less than one indicates any debts due within one year are greater than your current assets

References

1. Earnings and Cash Flows: A Primer on Free Cash Flow
2. The investor's bible
3. How a Cash Flow Statement works
4. How to Read a Balance Sheet