FCFE Vs FCFF: Understanding Free Cash Flow

The investing world is based on a quota of rules, regulations, and even speculations (Oh! We all love making our own theories about a stock's movement in the index, don’t we? 😉) But, all types of investors, traders, and analysts will agree that there are certain metrics and parameters to check while analysing a company.

Return On Equity (ROE), P/E Ratio, debt, etc., are some figures that give an insight into a company’s performance and health. Hence, skipping these financial ratios would mean spending your life’s hard-earned money blindly. 🙈

Do you know the financial metrics that pro-investors consider before adding stocks to their portfolio, apart from the ones mentioned above? If you guessed reviewing the company’s account statement, then you hit close to the mark. Sure, the Annual Account Statement provides a valuable overview of how the company is faring and its plans, but it’s not enough.

What you need is a business’ Free Cash Flow to know the accurate picture behind the glamour of profit growth. After taking care of all the expenses, operational or otherwise, the cash flow left is counted as the free cash flow. It is then bifurcated into two categories:

• Free Cash Flow to Equity, aka FCFE
• Free Cash Flow to the Firm, aka FCFF

In this article, we will understand what these metrics mean, both independently and collectively, and how to use them to make the right decisions in investing. Let’s begin by…

Understanding Free Cash Flow (FCF) with an Example

Suppose a company named ABC provides the following data in its annual account statement:

• Cash From Operations (CFO) = ₹10,000
• Capital Expenditure (Capex) = ₹6,000

Then, as per the formula,

FCF = Cash from Operations - Capex
FCF = 10,000 - 6,000
FCF = ₹4,000

In short, the free cash flow is the amount a company makes after removing expenses and certain liabilities from its operational earnings. Now, to calculate CFO, you will need to calculate various metrics and figures such as Net Income, Non-Cash Expenses, Change in Working Capital, etc.

In short, you might have to recall your mathematician skills from school days and get on with subtracting or adding with vigour. 🧑‍🎓 The same rule applies for calculating FCFE and FCFF.

Now, now! I know all these numbers make many of us queasy. So, let me simplify it to help you find a company’s true value like a pro. 😎

Let’s begin with the first category under FCF. It’s…   

Free Cash Flow to Equity (FCFE): Levered Cash Flow

FCFE is the crucial financial metric highly preferred by analysts and investors to gain knowledge about the cash a company has after paying off all the expenses. In technical terms, FCFE is the cash flow available to a company's equity shareholders, including common and preferred stockholders.

It represents the cash flow that can be distributed to the shareholders after accounting for capital expenditures, debt repayments, and other obligations. The official formula to calculate FCFE is:

FCFE= Net Profit + Depreciation - Change in Net Working Capital - Capex + Change in Debt

Since, CFO = Net Profit + Depreciation - Change in Net Working Capital, the formula can be simplified as;

FCFE= Cash From Operations−Capex + Net debt issued (Change in Debt)

If you wish to calculate FCFE utilising the EBIT or EBITDA of a company, then the formula would be:

FCFE = (EBITDA- Interest - Taxes - Depreciation & Amortisation) + Depreciation + Amortisation +/- Changes in Working Capital - Capex + Change in Debt

Don’t worry! You won’t have to spend hours searching these metrics from lengthy financial statements. Review the image below to save time. ⬇️

FCFE is often used in the context of valuing a company's equity or determining the potential dividends that can be paid to shareholders. As it includes the amount left after paying off taxes and liabilities, it is called the leveraged cash flow. Hence, this amount is not directly shown in a company’s annual statement, but you can check it instantly from Ticker by Finology.

Take Reliance Industries Ltd., for example. Here’s its FCFE ratio: ⤵️

Professional investors love FCFE because it is a powerful indicator of a company's long-term profitability and showcases its equity value. Companies with high FCFE are more likely to sustain their growth and dividends over time.

Free Cash Flow to the Firm (FCFF): Unlevered Cash Flow

FCFF is the financial metric which big companies with high leverage usually represent as the net free cash flow in account statements. In technical terms, FCFF measures the cash flow available to all investors in a company, including both equity and debt holders. It represents the core operational cash flow of the business.

Here’s the formula to calculate FCFF:

FCFF = Net Operating Profit After Tax (NOPAT) + Depreciation - Change in Net Working Capital - Capex

There is one more formula to calculate FCFF:

FCFF = Cash from Operations + Interest (1- Tax rate) - Investment in Fixed Capital + Net Borrowing

Since FCFF excludes the liabilities, it is called unlevered cash flow. This metric is also called the enterprise value as it gives the overall free cash flow amount of the firm. If you look at the "Company Essentials" portion for RIL at Ticker by Finology, you will find the enterprise value placed proudly. ⬇️

Now, it's time to compare the metrics side by side to gain further clarification.

FCFE Vs FCFF

FCFE, aka levered cash flow, is the capital a company has left after it has met varying financial obligations. In contrast, FCFF, aka unlevered cash flow, represents the capital a company has before paying off its obligations like taxes and debt.

Let’s further clarify the difference between the two by bifurcating their common grounds;

The Bottom Line

Thus, while analysing a company, it’s imperative to calculate both FCFE and FCFF. Where FCFE will help you find whether a stock is overvalued or undervalued, FCFF will give you an insight into the business’ minds regarding their company’s figures. So, make sure to add this metric to your checklist and keep making wise decisions for a fulfilling investment journey.

*Disclaimer: The stocks and companies discussed above aren't a recommendation from Insider by Finology and shall not be construed as a replacement for professional advice. Consult a professional or conduct the necessary research before making investment decisions.