Free cash flows

Free cash flows

Cash not required for operations or for reinvestment. Often defined as earnings before interest (often obtained from the operating income line on the income statement) less capital expenditures less the change in working capital. In terms of a formula:

Free cash flows =

Sales (Revenues from operations)
- COGS (Cost of goods sold-labor, material, book depreciation)
- SG&A (Selling, general administrative costs)
EBIT (Earnings before interest and taxes or Operating Earnings)
- Taxes (Cash taxes)
EBIAT (Earnings before interest after taxes)
+ DEP (Book depreciation)
- CAPX (Capital expenditures)
- ChgWC (Change in working capital)
C (Free cash flows)

There is an issue as to whether you want to define the FCFs to the firm as a whole (the cash flow to all of its security holders), or the FCFs only to the firm's equity holders. For firm valuation, you want the former; for stock valuation you want the latter.
To value the firm, calculate the stream of FCFs to the firm and discount this stream by the firm's WACC (Weighted average cost of capital). This will give you the value of a levered firm, including the tax benefits of debt financing. Alternatively, you can discount the firm's FCFs by its unlevered cost of capital and add separately the present value of the tax benefits.
To value the firm's equity, you can either take the above number and subtract the market value of all outstanding debt (liabilities) or you can calculate the FCFs to the firm's equity holders and discount this stream by the firm's levered equity cost of capital.
Notice that changes in working capital have the same effect on free cash flows as do changes in physical capital, i.e., capital expenditures. For example, suppose you had to spend $XX to increase the capacity of your plant. This expenditure would be a reduction in free cash flow in the year it was made. Likewise, if you had to increase the level of your cash balance, inventory or receivables by $XX to accommodate greater sales, then this too would result in a like reduction in free cash flows in the year the level of working capital was increased. [Definition and discussion courtesy of Professor Michael Bradley.]
Copyright © 2012, Campbell R. Harvey. All Rights Reserved.

Free Cash Flow

A measure of a company's ability to generate the cash flow necessary to maintain operations. There is more than one way to calculate free cash flow, but perhaps the simplest is to subtract a company's capital expenditures from its cash flow from operations. Some analysts believe that free cash flow is more important than other measures of financial health because it measures how much cash a company has and can make. This differs from other measures, which are sometimes accused of using both legitimate and illegitimate forms of accounting to make a company look healthier than it really is.
Farlex Financial Dictionary. © 2012 Farlex, Inc. All Rights Reserved
References in periodicals archive ?
The case for using free cash flows as the standard for financial health and well-being is restated in Figure 5.
This approach concludes that the assembled assets of the foundry are only worth what free cash flows they can generate as a going concern.
Auditors can also examine their clients' free cash flows. The company's free cash flows could be a piece of evidence when making a preliminary judgment about client risk and in carrying out some of the initial audit planning.
These figures are even more improved in Q1 02, where we've improved our operational free cash flows over the [previous] quarter.
In order to examine the stability of free cash flows, Exhibit 4 also reports each industry's free cash flow coefficient of variation (CV).
Concerning the concept of free cash flows, two points should be emphasized: First, increasing reliance is being placed on free cash flow numbers by a variety of users, including investor analysts, credit analysts, and finance and economics theoreticians.
In a companion piece to his article in the last issue, Robert Howell turns his attention to the importance of free cash flows in determining valuations.
Cash Earnings and Free Cash Flows Managers and investors should focus on "cash earnings" and the reinvestments that are made into the business in the form of "working capital" and "fixed and other (including intangible) investments." The net amount of these cash flows represent the business's "free cash flows."
In a recent study of 25 blue-chip stocks across industries, Howell found that most were severely overvalued at today's prices and that current free cash flows cannot support most companies' current market prices.
SunTrust analyst Tobey Sommer raised his price target on SAIC to $100 and kept his Buy rating, saying the company's integration of Engility could drive its free cash flows higher and making the stock look "cheaper" on cash flow yield valuation basis.
Total free cash held by the industry firms in our research sank to the most recent low during the third quarter of 2017; but they reversed course and have since increased quarterly free cash flows, culminating in a multi-year high at the end of 2018.
Ebitda also fails to account for the annual capital expenditures and working capital requirements of the company, thereby overstating its free cash flows.