In this article, we are going to see what Free Cash Flow is, what types are there, and how to calculate it.
What is Free Cash Flow?
Free Cash Flow (or Free Cash Flow) is the amount of money that a company is capable of generating to meet its different obligations. We can mainly differentiate two types of Free Cash Flow depending on whether we include financing or not. Next, we are going to differentiate them:
- Free Cash Flow Unlevered (or debt service): is the money generated by the company from its operations, without taking into account interest or tax shield. It is the Cash Flow that will be used when valuing a company since it measures its real capacity to generate cash for the company’s main business. It is also known as FCF for debt service since it allows us to see the debt that the company will be able to assume.
- Free Cash Flow Levered (or for shareholders): it is the money generated by the company, including the acquisition of new debts with their interests and their amortization, and their corresponding tax shield. It is also known as FCF to equity since it is the money that will be available to pay shareholders.
We are now going to explain step by step the formula used in the video to understand how the calculation of both Free Cash Flows works.
How to calculate the Free Cash Flow Unlevered / for debt service?
- EBITDA: we will only have to take the EBITDA line, which will include sales – COGS (Cost of Goods Sold) – OPEX (Operative Expenses).
- Movements in Accounts Receivable (variations in accounts receivable): the formula to be applied will be the amount of the current year of our balance – the amount of the previous year. In this case, an increase will be negative since it assumes that we will have made sales but that customers have not paid us and, therefore, it will imply a reduction in cash concerning the sales that we have previously included in EBITDA.
- Movements in Inventory: in this case, the formula will be the same as in the previous point, the amount of the previous year must be subtracted from the current year. If the inventory account increases on our balance sheet, it will mean negative cash flow, since it is a cost for the company.
- Movements in Accounts Payable (variations in accounts pending payment): in this case, the opposite will happen, we must subtract the amount of the previous year from the current year. If the balance increases, we will have a positive cash flow, since the company will have received a product or service but has not yet paid for it, with which we have to offset an expense that we have included in our EBITDA that has not been a cost yet. cash out.
- The variations of accounts receivable, inventory, and payable represent the variations in working capital.
- CAPEX (Capital Expenditures): is the investment made by the company in fixed assets, therefore it represents a cash outflow.
- Cash taxes: these are the taxes that the company pays in a period, but it does not necessarily have to coincide with the taxes that it should pay based on the profit and loss calculation; we will only include those paid (cash outflow)
- Tax shield (or fiscal shield): these are the taxes that the company has stopped paying due to its financial expenses. If the company had no debt, and therefore no interest expense, its EBT (Earnings Before Tax) would have been higher, so it would have paid more taxes. This would have meant an expense for the company and, therefore, a higher cash outflow than what we have reflected in the previous point.
How to calculate the Free Cash Flow Levered / to equity?
Continuing with the previous result, we must include a series of items to obtain the FCF Levered:
- Cash interests: they are the financial expenses that the company has had for the interests of the debt and will mean a cash outflow.
- Tax shield: here we will do the opposite of what we have done in FCF Unlevered; as we are including our financial expenses, this will mean a reduction in our EBT and, therefore, we will pay fewer taxes, which will mean a cash inflow.
- Cash debt: we will subtract from the current amount of the balance the amount of the previous year. It is the money that comes in and goes out of the box due to the debt, whether we acquire new debts (inflows) or if we amortize existing ones (exits).
How to calculate Cash Flow (Total Change in Cash & Equivalents)?
Although the objective of this article is to explain only Free Cash Flows and learn how they are calculated, we are going to see how the final Cash Flow can also be obtained, which will then be reflected in the balance through Free Cash Flows. As we see in the video, I will only need to include two more games:
- Cash equity: we will have to subtract from the current year the amount of the previous year. It may involve a cash inflow if there are capital increases or an outflow if there are capital reductions.
- Cash dividends: it will mean a cash outflow since it represents the payment of dividends to shareholders.
With all of the above, we will obtain the Cash Flow, which will represent the Cash Flows of the company during a specific period, and if we add to this amount the Cash Flow of the previous years, we will obtain the Accumulated Cash Flow, which we will see reflected in the cash of our balance.