Free Cash Flow (FCF) calculations are an important method for measuring the financial well-being of a company. In simple terms, free cash flow represents cash that is available to pay for planned expenditures such as new manufacturing facilities and equipment, or paying down debt. FCF may be considered the available cash that a company has to invest in development of future growth opportunities.

Free Cash Flow’s Relationship to Capitalization

Capitalized expenditures pay for work that substantially improves facilities or equipment by maintaining facilities in good operating condition, or returning underutilized facilities to functional use. Capitalized expenditures used to maintain a facility in good operating order usually increase the property’s value. Capitalized expenditures are also used to upgrade facilities in order take advantage of new opportunities and forecasted growth potential.  There are several approaches to calculating free cash flow and the relationship to capitalized expenditures. The following formulas are just a few of the various free cash flow calculations that investors use to measure the financial well-being of a company. The first approach is from Investing Answers.com.

Free cash flow (FCF) is a measure of how much cash a business generates after accounting for capital expenditures such as buildings or equipment. This cash can be used for expansion, dividends, reducing debt, or other purposes.

The Formula for free cash flow is: FCF = Operating Cash Flow – Capital Expenditures

The next formula comes from Value Based Management.net.

Net Operating Profit After Taxes – Net Investment – Net Change in Working Capital = FCF

The next formula comes from Wall Street Oasis.com®, and is a much more complex way to calculate FCF.

Free Cash Flow (FCF)

Unlevered FCF = Free Cash flow to Firm (FCFF) = EBIT (1-T) + D&A – Change in Noncash WC – CAPEX

The FCFF represents the cash flows available to ALL investors after mandatory cash outflows for business needs have been taken out (including taxes).

The reason we need FCF instead of EBITDA and OCF is the CAPEX adjustment. Any capital intensive company will be spending money on a regular basis to buy/modify/upgrade/replace their fixed assets (stores, machines, equipment, airplanes). Capex can represent a significant reduction in cash flow for many of these companies. Look at the Cash Flow Statement for any of the airlines to see the effect. Capex is an ongoing, operational cash outflow that must be considered.

EBITDA is defined as: Earnings Before Interest Taxes Depreciation and Amortization

EBITDA = Operating Income + Depreciation + Amortization
= EBIT + Depreciation + Amortization
= Net Income + Income Tax Expense + Interest Expense + Depreciation + Amortization

Different Cash Flow Calculations for Toyota Motor Company

The following data clearly represents how variations in cash flow calculations affect free cash flow figures.  The first data set comes from MarketWatch.com.

For the year ending March 2011:

Net Operating Cash Flow … 2.02T

Net Investing Cash Flow … (2.12T)

Net Financing Cash Flow … 434.33B

Exchange Rate Effect ……. (127.03B)

Net Change in Cash ………. 214.96B

Free Cash Flow …………… 191.7B

Data provided by Forbes.com for the same reporting period provides a much different free cash flow number.

(All the numbers were provided in thousands)

Total Current Assets …………….. 142,733,530

Total Assets ……………………… 359,775,168

Total Liabilities ………………………. 235,108,530

Total Liabilities & Stock Equity … 359,775,168

Cash Flow ………………………… 19,109,025

Working Capital …………………. 12,533,361

Free Cash Flow ……………………. 2,312,958

It is easy to see how much different the free cash flow numbers are between these two data sets. The data published by MarketWatch is based on operating cash flow, and the data published by Forbs is based on the company’s assets and liabilities. The differences are very important when you try and calculate the free cash flow ratio. The following formula for free cash flow ratio comes from Investopedia.com.

Formula:

Using this formula, the data from two examples would provide far different free cash flow ratios. The important point to remember is when people say a company is trading at a certain free cash flow ratio; you need to be aware of what FCF calculation method was used, and what financial data set was used to come up with the data set for the calculation