What is Free Cash Flow and How does it work?
Free cash flow, often abbreviated as “FCF, is an efficiency and liquidity ratio that determines how much more cash a firm earns than it uses to operate and grow its business. It is calculated by deducting capital expenditures (CAPEX) from operational cash flow. For investors, free cash flow serves as an indicator of a company’s financial performance, which affects how much a company is worth. For small business owners, FCF helps them figure out if their business can grow, change, or make more money.
What are the types of Free Cash Flow
It is not always clear what is meant when someone mentions FCF. People may be referring to one of several metrics.
Here are the two most common types:
- Free Cash Flow to the Firm (FCFF). This is the cash flow available to all funding providers (debt holders, preferred stockholders, common stockholders, convertible bond investors, etc.). It indicates the excess funds that a company would have if it had no debt.
- Free Cash Flow to Equity. This is the amount of cash that a company generates that could eventually be distributed to shareholders. It is determined by subtracting net debt issued from capital expenditures and adding cash from operations.
How Free Cash Flow Works
When a business has positive free cash flow, it can pay all of its monthly bills and still have money left over. Businesses that are performing well and have rising or high free cash flow metrics may desire to grow. Growing the free cash flow of a company attracts investors. These businesses can invest their extra income to get a return. On the other hand, if there is little money left over after paying for business expenses, the free cash flow is minimal. Because of this, investors may be less interested in the company because it may be less likely to make money in the future.
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