Free Cash Flow to Firm: Explained

What is it, how to calculate it, formula, why it's important

Hey guys and gals, today I wanted to chat with you about what might be the nerdiest thing I've ever loved - Free Cash Flow to Firm (FCFF). But hear me out, because when you get to the end of this article, you'll know why FCFF is one of the most important things to consider when making investment decisions.

What is Free Cash Flow to Firm?

Simply put, FCFF is the amount of cash that a company generates after accounting for all its expenses and investments necessary to keep the business running. This is important because it tells investors how much cash a company has left over to use however they please - whether it's investing in new projects, buying back shares, or paying out dividends.

Here's an example: Let's say you run a lemonade stand. You have to pay for all the lemons, sugar, cups, and labor every day, and some days are better than others in terms of sales. FCFF would be the cash that you have left over at the end of the day after all those expenses have been accounted for.

Why is FCFF important?

FCFF is important because it shows investors the true financial health of a company. If a company has a growing FCFF, it means that they are generating more cash each year, which can be used to invest in new projects, expand their business or pay out dividends to shareholders. On the other hand, a declining FCFF might signal that the company's financial situation is weakening or they are facing higher expenses that they can't manage.

How is FCFF calculated?

The formula for calculating FCFF is a bit complex, but bear with me here. The equation goes like this:

FCFF = EBIT(1-T) + Depreciation & Amortization - Capex - Change in Net Working Capital

Let me break that down for you:

EBIT(1-T): Earnings before interest and taxes, minus the tax rate. EBIT represents the operating income of a business before any interest expenses or taxes are factored in.

Depreciation & Amortization: This is the decrease in value of long-term assets over time. A company might invest in a property or machinery that could last for several years, and this expense is accounted for in FCFF by subtracting it.

Capex: Capital expenditure represents the amount of money that a company spends on investments in long-term assets that will drive future growth - for example, a new factory.

Change in Net Working Capital: This represents the difference between a company's current assets and liabilities. It reflects the increase or decrease of short-term assets such as inventory and accounts receivable.

An example of FCFF calculation

Let's use Apple Inc. as an example. In 2020, Apple reported an EBIT of $66.3 billion, a tax rate of 20.7%, depreciation and amortization of $11.3 billion, capital expenditures of $8.2 billion, and a change in net working capital of $1.7 billion.

Using the FCFF formula, we can calculate Apple's FCFF as follows:

FCFF = EBIT(1-T) + Depreciation & Amortization - Capex - Change in Net Working Capital

= $66.3 billion x (1-0.207) + $11.3 billion - $8.2 billion - $1.7 billion

= $47 billion

What does a high or low FCFF tell us?

A high FCFF means that the company has a lot of cash on hand after paying for all its expenses, which can be used to pay out dividends, invest in new projects, or expand the business. This is a good sign for investors, as it shows that the company is financially healthy and has room to grow.

On the other hand, a low FCFF might indicate that the company is struggling financially and has less cash flow available for new investments or shareholder payouts. This might make investors wary, as it could signal a potential decline in the company's stock price.

In conclusion

So there you have it folks, the ins and outs of Free Cash Flow to Firm! I hope you see now why this number is so important for investors to understand when making investment decisions. A growing FCFF can mean good things for a company's future, while a declining FCFF might be a sign of trouble.

Remember, FCFF can be difficult to calculate sometimes, but it's important to take the time to understand it before making any investment decisions. Happy investing!

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