Calculating Free Cash Flow
Free Cash Flow (FCF) is a crucial financial metric that indicates a company’s ability to generate cash after accounting for all its operating and capital expenditures.
FCF is a valuable tool for investors, analysts, and managers, as it provides insights into a company’s financial health and its potential for growth.
formula for FCF = NOPAT — Capital Expenditure + Depreciation — Change in Working Capital + Any Asset Sale or Salvage Value.
Net Operating Profit After Tax (NOPAT)
The first component of the FCF formula is NOPAT, which stands for Net Operating Profit After Tax.
NOPAT is a measure of a company’s profitability after accounting for taxes but before considering interest and other financing-related expenses. To calculate NOPAT, you can use the following formula:
NOPAT = Net income in Balance sheet
Capital Expenditure (CapEx)
Capital Expenditure represents the funds a company invests in its long-term assets, such as equipment, buildings, or machinery.
CapEx is a critical component of FCF because it reflects the investments needed to sustain and grow the business.
To calculate CapEx, you can use the following formula:
CapEx = in case flow statement
Depreciation
Depreciation represents the allocation of the cost of a long-term asset over its useful life.
It’s like spreading of jam over bread. jam is a capex and bread is a firm when it is spread over it, it's like spreading it over the year. so, company announcing big investment are likely spread over the years.
While it is a non-cash expense, it is subtracted from NOPAT in the FCF formula because it reflects the wear and tear on a company’s assets. it generally happens in income statement, gov allows for it and its tax free.
Depreciation is added back to NOPAT to determine the cash generated by the operations. since its a non cash expenditure it is added back.
Change in Working Capital
Working capital is the difference between a company’s current assets and current liabilities.
Changes in working capital affect a company’s cash flow. An increase in working capital (current assets exceeding current liabilities) requires more cash, while a decrease in working capital provides additional cash.
The formula for calculating the change in working capital is as follows:
Working capital = Current Asset — Current Liabilities
Change in Working Capital = Working Capital of Year 2- Working Capital of Year 1
Change in Working Capital = (Current Assets(year2) - Current Liabilities(year2)) — (Current Assets(year1) - Current Liabilities(year1))
Any Asset Sale or Salvage Value
If a company sells assets or receives salvage value from the disposal of assets, this can either contribute to or subtract from its FCF.
Any proceeds from asset sales or salvage value should be added to the FCF calculation.
Calculating Free Cash Flow
Now that we have covered the components, let’s put it all together to calculate Free Cash Flow:
formula for FCF = NOPAT — Capital Expenditure + Depreciation — Change in Working Capital + Any Asset Sale or Salvage Value.
By plugging the values for each component into the formula, you can determine a company’s Free Cash Flow, which represents the cash available for various purposes, including reinvestment, debt reduction, dividends, or acquisition.
Free Cash Flow is a critical metric for evaluating a company’s financial performance and potential for growth.
By understanding the components of FCF and how to calculate it, investors and analysts can make more informed decisions.
Monitoring FCF over time allows stakeholders to assess a company’s financial health and its capacity to create value for shareholders.
Thank you for reading.
