What is Free Cash Flow ?

What is Free Cash Flow?

Free cash flow is a cash flow available in a company after paying operating expenses, debt and other obligations. It does not include the non cash expenses like depreciation.

 

Formula:

FCF =Net income + Depreciation + Interest expense*(1-tax rate)-Increase in net working capital-Capital expenditure.

OR

FCF =EBIT*(1-tax rate) + Depreciation-Increase in net working capital/+Decrease in net working capital-Capital expenditure

 

Where,

FCF=Free Cash Flow,

EBIT = Earnings before Interest and Tax

Capital expenditure = Cost of Asset

 

Example: The LX Company wants to purchase a machine worth Rs. 90,000. The life of asset is 5 years and the salvage value is Rs. 2800. The increase in net working capital is Rs. 45,820.The earnings before interest and tax is Rs. 4, 50,000. The company tax rate is 35%. What is the free cash flow of a LX Company?

 

Solution: Depreciation on machine:

= (Cost of machine-Salvage value)/Useful life of machine

= (90000-2800)/5

= 87200/5

=Rs.17440

 

The free cash flow of LX Company:

FCF =EBIT*(1-tax rate) + Depreciation-Increase in net working capital -Capital expenditure

= 450000*(1-0.35) +17440-45820-90000

= 292500+17440-45820-90000

= 309940-45820-90000

= 264120-90000

=Rs.174120

 

Example: Find out the free cash flow of a company WX with the help of income statement for the year ended 2021.

 

Particulars	Amount
Sales	80000
Less: Cost of goods sold	20000
Gross profit	60000
Less: Operating expenses	25000
Operating profit	35000
Less: Tax rate 30%	10500
Net income	24500

 

The Balance sheet of 2020 and 2021 are given below:

Assets	2020	2021
Current Assets:
Cash and cash equivalents	2400	3000
Short term investments	8000	5400
Accounts receivables	9000	7000
Inventory	25000	30000
Total current assets	44400	45400
Long term Investments	260000	125000
Property, plant and equipment	277600	314600
Less: Accumulated Depreciation	12000	10000
Net property plant and equipment	265600	304600
Total Assets	570000	475000
Liabilities and shareholder’s equity
Current liabilities:
Accounts payable	20400	15000
Notes payable	15000	12000
Accrued expenses	5400	3400
Total current liabilities	40800	30400
Long term liabilities	240000	160000
Owner’s equity:
Common stock	200000	200000
Retained earnings	89200	84600
Total liabilities and shareholder’s equity	570000	475000

 

The depreciation amount Rs. 8000 in 2021.

 

Solution: Change in working capital:

 

Particulars	2020	2021
Total current Assets	44400	45400
Total current liabilities	40800	30400
Net working capital	3600	15000
Change in working capital	11400

 

 Net working capital= Total current assets-Total current liabilities

Change in Working capital = Net working capital of 2021- Net working capital of 2020

EBIT = Rs. 35000

Tax rate = 30%

Depreciation expense=Rs.8000

Net property, plant and equipment of 2021= Rs.304600

Net property, plant and equipment of 2020 = Rs. 265600

 

Capital expenditure:

=Net property, plant and equipment of 2021-Net property, plant and equipment of 2020 + Depreciation expense

=304600-265600+8000

= Rs.47000

 

Free Cash flow to company:

=EBIT*(1-tax rate) + Depreciation expenses-Increase in change in working capital-Capital expenditure

=Rs. (35000*(1-0.30) + 8000-11400-47000

= Rs. (35000*0.70+8000-11400-47000

= Rs. (24500+8000-11400-47000

= Rs. (32500-11400-47000)

= Rs. (21100-47000)

= -Rs. 25900

 

The free cash flow of a company WX is –Rs.25900. It means company spend more money on operation than it generate as revenue.