What is FCFF?
FCFF—or Free Cash Flow to Firm—is the excess cash generated by a company’s core operations attributable to all capital providers, inclusive of equity shareholders, preferred stockholders, and debt lenders.
Often used interchangeably with the term “Unlevered Free Cash Flow”, free cash flow to firm (FCFF) accounts for all recurring operating expenses and re-investment expenditures, such as capital expenditures (Capex) and working capital requirements, while excluding the cash outflows that pertain to debt lenders, like interest expense payments.
How to Calculate Free Cash Flow to Firm (FCFF)
The free cash flow to firm (FCFF) metric is the cash available to all the firm’s stakeholders, which comprise debt lenders, preferred stockholders and common shareholders.
Simply put, FCFF is the remaining cash generated from the core operations of a particular company, after adjusting for core operating costs and capital expenditures (Capex) necessary to remain operating.
Before we discuss the formulas used to calculate the free cash flow to firm (FCFF), it is important to cover what this metric is intended to portray and discuss the standards used to determine which types of items should be included (and excluded).
- Core Operations (Operating Items) ➝ The FCFF value must reflect only the core operations of the business – each line item included should be strictly from the recurring sale of goods or services sold to customers. For example, the cash proceeds from a one-time asset sale should be left out of the calculation as it is neither recurring nor is it part of the business.
- Normalization ➝ The FCFF figures should also be normalized to set apart the recurring performance of the company. Given that one of the main use cases of FCFF is for projection models, most notably the DCF model, each item must be expected to be ongoing into the future.
- Discretionary Items ➝ The discretionary line items that pertain to only one specific group (e.g., dividends) should also be excluded. This ties back to the theme of FCFF applying all providers of capital. The payout of dividends benefits only equity shareholders and is a discretionary decision up to management while being unrelated to core operations.
- Stakeholders Representations ➝ FCFF corresponds with the enterprise value (TEV) and the weighted average cost of capital (WACC) as the three metrics all represent all stakeholders in a company.
FCFF Formula
Starting off, to calculate free cash flow to firm (FCFF) from earnings before interest and taxes (EBIT), the first step is to tax-affect EBIT.
EBIT is an unlevered profit measure since it is above the interest expense line and does not include outflows specific to one capital provider group (e.g., lenders).
The tax-effected EBIT is also commonly known as:
- EBIAT ➝ “Earnings Before Interest After Taxes”
- NOPAT ➝ “Net Operating Profit After Taxes”
The formula to compute NOPAT, or “EBIAT,” is equal to operating income (EBIT) multiplied by one minus the tax rate.
Once NOPAT is calculated, the next step is to add back non-cash items, namely depreciation and amortization (D&A), since those expenses are not actual cash outflows.
However, remember the rule that each item included must be recurring and part of the core operations—thereby, not all non-cash items are added back (e.g., inventory write-downs).
From that point onward, the reinvestment needs of a company—capital expenditures (Capex) and the change in net working capital (NWC)—are deducted.
Of the outflows in the cash from investing (CFI) section, the major line item that should be accounted for is Capex, which refers to the purchase of fixed assets (PP&E).
Unlike working capital, which cycles out rather quickly, Capex is a long-term investment, wherein the PP&E provides positive economic utility on behalf of the company in excess of one year (or twelve months).
The reasoning for the necessity to allocate funds toward Capex is to sustain current operations into the foreseeable future, which is formally termed “Maintenance capex”, and to grow and expand operations, referred to as “Growth Capex”.
The relationship between the change in NWC and free cash flow (FCF) is as follows:
- Increase in Net Working Capital (NWC) ➝ Less Free Cash Flow (FCF)
- Decrease in Net Working Capital (NWC) ➝ More Free Cash Flow (FCF)
To provide two examples explaining the rationale behind NWC:
- Increase in Current Operating Asset ➝ If a current operating asset such as accounts receivable (A/R) were to increase, that means the company is being less efficient at collecting cash from customers that paid on credit – in effect, the amount of cash on hand is reduced
- Increase in Current Operating Liability ➝ If a current operating liability like accounts payable (A/P) were to increase, then that suggests the company has not yet paid suppliers/vendors for due payments – while the payment will still eventually be paid out, for the time being, the cash is in the possession of the company
Capex and increases in NWC each represent outflows of cash, which means less free cash flow remains post-operations for payments related to servicing interest, debt amortization, etc.
Putting the above all together, the FCFF formula starts with NOPAT, which must be adjusted for D&A and the change in net working capital (NWC), and then subtracted by Capex.
How to Normalize Free Cash Flow to Firm (FCFF)
Normalizing cash flows becomes particularly relevant when performing trading comps using FCFF-based multiples, in which the target company and its comparables (i.e., the target’s peer group) are benchmarked against each other.
For the comparison to be as close to being “apples to apples” as possible, the non-core operating income/(expenses) and non-recurring items should be adjusted out to prevent the output from being skewed.
FCFF Calculator — Excel Template
We’ll now move on to a modeling exercise, which you can access by filling out the form below.
1. FCFF Calculation Example (EBITDA to FCFF)
If we start the calculation from EBITDA, the minor difference is that D&A is subtracted and then added back later – and so, the net impact is the tax savings from the D&A.
Based on the assumptions listed, the EBITDA is $25m, from which we deduct $5m in D&A to get $20m as the EBIT. And to calculate NOPAT, we apply a 40% tax rate to the $20m of EBIT, which comes out to $12m.
From the $12m in NOPAT, we add back the $5m in D&A and then finish the calculation by subtracting the $5m in capex and $2m in the change in NWC – for an FCFF of $10m.
2. FCFF Calculation Example (Net Income to FCFF)
An alternative formula to calculate FCFF starts with net income, which is a post-tax and interest metric.
Next, we add back the relevant non-cash expenses, like D&A.
The D&A and change in NWC adjustments to net income could be thought of as being analogous to calculating the cash flow from operations (CFO) section of the cash flow statement. Then, the interest expense is added back since it pertains only to lenders.
In addition, the “tax shield” associated with interest must be added back, too (i.e., the tax savings). The interest on debt lowered the taxable income – thus, the interest must be multiplied by (1 – Tax Rate).
In effect, the impact of interest is removed from taxes – i.e. the “tax shield” – which is the objective of NOPAT (i.e., capital-structure neutral).
To make sure this point is clear, the FCFF is available to both creditors and equity holders, so we are working towards calculating figures on a “before interest” basis since we are starting from cash from operations (CFO), i.e. an after-tax metric.
Therefore, to get to a value that represents all providers of capital, we add back the interest expense amount as adjusted for the fact that interest is tax-deductible.
Since D&A added to net income and is now free of debt-related payments (and side impacts), we can proceed with deducting the re-investment needs: the change in net working capital (NWC) and Capex.
3. FCFF Calculation Example (Cash from Operations to FCFF)
The next formula for calculating FCFF starts with cash flow from operations (CFO).
On the cash flow statement, the CFO section has the “bottom line” from the income statement at the top, which is then adjusted for non-cash expenses and changes in working capital.
However, be careful not to merely pull the cash flow from operations (CFO) figure without confirming the non-cash charges are indeed related to the core operations and are recurring.
After doing so, we add back the tax-adjusted interest expense, following the same logic as the prior formula.
In the final step, we subtract Capex since it represents a required cash outlay. There is no need to deduct the change in NWC this time around since cash from operations (CFO) already takes it into account. But Capex is located in the cash flow from investing (CFI) section and thus was not yet accounted for.
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