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Definition: Free Cash Flow for the Firm – FCFF
It is the net amount of cash in the firm consisting of taxes, expenses and changes in investment and net working capital. It is one of the instruments to describe a company’s financial health and shows the company’s profitability after all the expenses and reinvestments. It basically denotes all the cash available in the business to pay to its investors after the company expenses its costs of doing the business, and invests in short term and long term assets.
Below shown is the basic formula to calculate FCFF:
FCFF = EBIT (1-t) +Depreciation & Amortization-capital expenditures – changes in working capital.
EBIT: earnings before interest and tax
Capital expenditure: Expenditures made to fund long run assets or investments.
Changes in working capital: working capital is the fun used to meet short run or current expenses. It is the difference between current assets and current liabilities.
Cash flows out of the business when company pays its expenses in terms of salaries, rent, and taxes, and cash flows in when the company sell its products. To continue with its operations, the company continually invests in itself and maintain its short term assets and buys more long term assets to increase productivity.
Once all these activities are done, payment of expenses and reinvestment, the company pays interest or principal to its investors. To obtain the amount of money available of free in the business to pay to its investors, FCFF is calculated.
Apart from above, the FCFF calculated for the firm is used in valuation models for evaluating company’s stock. A stock is simply a sum of future cash flows when put in present value of money. Also a company which has potential future cash flow can pay a promising dividend for a stock. Thus the calculation of FCFF is used widely in doing the technical analysis of the company’s stock.