I have a question which is confusing me a bit related to Free Cash Flow:
One of the formulas provided is: FCFF = CFO + [Interest x (1 - tax rate)] - FCInv
CFO = cash flow from operations, Interest = interest expense, FCInv = fixed capital investment
Now in this FCFF formula, we don’t substract any “working capital investment” (WCI) [WCI = current assets - current liabilities]. In the “net income” based FCFF formula, that is subtracted. Substantially, this makes sense. In calculating CFO from net income (indirect method), we add liabilities (e.g. wages payable) and subtract non cash assets (e.g. accounts receivable). Therefore, many components of WCI is already subtracted from / added to net income to get CFO - subtracting WCI again will be double counting for many items.
However, what about the “cash” aspect of working capital investment? Lets say that current assets is largely “cash” due to the company expecting some unforeseen circumstances. Therefore, WCI is largely made up of this stockpile of cash. This cash asset will NOT be subtracted from net income in calculating CFO (unlike accounts receivable) - since it’s cash. However, we want to retain this amount in the company without distributing it out based on the FCFF calculation. e.g. the management feels that it is absolutely necessary to keep $1M on hand for something crazy that might happen, but in calculating CFO from net income using the indirect method, this cash is not subtracted. However, it NEEDS to be subtracted before calculating FCFF since we DON’T want to distribute it and want to retain it. How can this be accomodated in the above FCFF formula?
Hi S2000magician. Thanks. I like that straightforward definition. Schweser for example says this “Free cash flow to the firm (FCFF) is the cash available to all investors, both equity owners and debt holders.”. That’s why I was wondering about the cash that the firm may want to retain without wanting to distribute to the stakeholders.
That being said, here is another definition of FCFF provided in the Schweser notes (based on NI):
FCFF = NI + NCC + [Int x ( 1 - tax rate)] - FCinv - WCinv -----------> (1)
where:
NI = net income NCC = noncash charges (depreciation and amortization) Int = interest expense FCinv = fixed capital investment (net capital expenditures) WCinv = working capital investment For your reference, the formula from first message is as follows: FCFF = CFO + [Interest x (1 - tax rate)] - FCInv ------------> (2) Lets say that Interest = 0, FCInv = 0, and NCC = 0. Lets also say that current assets (cash) = $6000, and current liabilities / wages payable = $5000. In this case, formula (1) reduces to: FCFF = NI + NCC + [Int x ( 1 - tax rate)] - FCinv - WCinv FCFF = NI + (0) + (0) - (0) - (6000 - 5000) FCFF = NI - 1000 ----------> (3) Using formula (2), FCFF = CFO + [Interest x (1 - tax rate)] - FCInv FCFF = CFO + (0) - (0) = CFO But, based on the indirect method of obtaining CFO from NI, the non-cash liability should be added to NI. The current asset is cash, so we don’t have to do anything with it. Therefore, CFO = NI + non-cash liabilities / wages payable = NI + $5000 Therefore, FCFF = NI + $5000 --------------> (4) Why doesn’t (3) and (4) equal to each other? They were derived from (1) and (2) respectively. Obviously, there is a mistake somewhere in my accounting - I just don’t see it. Thanks again. PS: I could just memorize the two formulas - but this inconsistency in my understanding of these alternative formulations is really bugging me…
I think it is because that WCinv is the working capital “invested” in the current year, it not the working capital itself of the current year. If I am not wrong, WCinv shall be the difference between the working capital of this year and the working capital of last year. The WCinv can not be calculated in your example. S2000magician, please correct me if I am wrong !
Thank you both. Fair enough. Ok, so lets say the difference between “the working capital of this year and the working capital of last year” is $2000 (cash).
FCFF = NI + NCC + [Int x ( 1 - tax rate)] - FCinv - WCinv ———–> (1)
Formula (2) doesn’t have a WCInv element. For the two FCFF values to be the same, the CFO calculation from NI using the indirect method must subtract the value from NI. At which step below (Schweser guide), should you subtract the WInv from NI to arrive at the base CFO value? – so that subsequently, you don’t have to subtract it in formula (2) to be consistent with formula (1). Step 2 talks about the gains/losses from the investment - not the principal of the investment. So, this has to fit under step 3 or step 4 below. My guess is (3), but wouldn’t that depend on the type of investment? (i.e. a money instrument or not?) Thanks!
[Straight from the Schweser guide re: calculation of CFO from NI using indirect method]:
The steps in calculating CFO under the indirect method can be summarized as follows: Step 1: Begin with net income. Step 2: Subtract gains or add losses that resulted from financing or investing cash flows (such as gains from sale of land). Step 3: Add back all noncash charges to income (such as depreciation and amortization) and subtract all noncash components of revenue. Step 4: Add or subtract changes to balance sheet operating accounts as follows: • Increases in the operating asset accounts (uses of cash) are subtracted, while decreases (sources of cash) are added. • Increases in the operating liability accounts (sources of cash) are added, while decreases (uses of cash) are subtracted.
haha! That’s funny :). Well, it’s a good thing that I don’t argue! Ok, so what I am going to gather from all these formulas and your responses is that – DON’T necessarily depend on these formulas and just understand the general concept. The reason I say that is b/c if formulas have omissions/assumptions that may not be generally justified, I don’t see a point in getting too caught up in any particular formulation. So I think it’s better if I direct my questions to the general notion of FCFF. You said earlier that “FCFF means cash available to the firm, for whatever use the firm deems appropriate, foreseen or not.”. With that definition, I’ll describe my current (somewhat limited) understanding. Hopefully it’s on the right track! Here goes… There are 3 cash flow classifications: 1) CFO, 2) CFI (investing activites), and 3) CFF (financing activities). Here, CFO + CFI + CFF = CHANGE in cash balance. Therefore, the cash flow calculations are NOT about the total cash balance, but about delta in cash balance for that particular operating cycle. Therefore, the FCFF calculation, which is based on CFO or net income (depending on formulation) is also a “delta measure”. In the sense that it is not the TOTAL cash that is available - but a “change” in the “cash availale to the firm” - a sort of a “gain in liquidity” if you will. So, an extremely wealthy company with a lot of cash sitting in a chequing account (for whatever reason) can still have a negative FCFF if they have a bad year (or quarter). As discussed earlier, two popular formulations of FCFF are based on net income and CFO as base values. Therefore, it appears that what the company does with investing activities (except for fixed capital investment) and financial activities are not relevant. So conceivably, if a fruit company uses all of its cash in the books (including all the new positive operating cash flow in the current period) to buy a Casino in Vegas (for some odd reason) as an investing property, the FCFF will NOT catch that. So, even though in “reality” all the cash is completely tied down and there is no liquidity, FCFF can still show some positive value. In calculating FCFF, when we use net income as the base, we subtract increases in NON-CASH asset accounts (e.g. accounts receivable) and add increases in NON-CASH liability accounts (e.g. wages payable). So, even if a company by law is required to spend all of its cash (existing cash and new operating cash flow) to pay its employees for wages, FCFF will NOT recognize this lack of choice and may indicate a high FCFF value - even though after paying the wages, it may not have any cash “to do as it pleases”. Moreover, we subtract FCinv from this b/c that capital investment is required to keep the company running. Here, I am presuming this is the ADDITIONAL FCinv that is required compared to the PREVIOUS period (i.e. the delta FCinv compared to previous year’s fixed capital). The fixed capital being things like a factory. the reason I thought this is a delta measure is b/c, otherwise, if a company has a huge factory that is very expensive, that would nullify any positive value in the FCFF calculation when we subtract the “value” of the factory. Now, if I am right about the above, WCInv is the big one that’s giving me some trouble conceptually. Asuka wrote (to which you agreed to) that “If I am not wrong, WCinv shall be the difference between the working capital of this year and the working capital of last year.”. Wages payable discussed above (which we add to net income to calculate FCFF) is part of current liabilities. Given WCInv is talking about the delta between working capital of this year and last year, I am unsure what WCInv is referring to. Lets say the ONLY current liability that is present is wages payable and last year it was $5000 and this year it was $6000. Lets also say that current assets (all cash) was $10K in both years. I am presuming we add $6000 to nullify wages payable and subtract $1000 to remove WCInv. But, I am not understanding the reason for this treatment. Can you please tell me the correct treatment of this in calculating FCFF? The correct numbers will hopefully help me understand exactly what we are doing and more importantly, WHAT we are trying to achieve by calculating FCFF - given all the caveats which I (hopefully correctly) identified above. I have more questions, but I thought it would be better to see if my understanding is correct up to this point. As always, thanks very much S2000magician!
CFO, CFI, CFF, FCFF and FCFE all are referring to “current year’s cash flows”, rather than the accumulated cash flows. That is, “cash flows” shall mean the cash flows into (out) the company in the year accounted for and they are irrelevant to any cash flows (and activities) in previous years, as well as the cash accumulated in previous years.
The WCInv is simply the reconciliation between net income and CFO. What you want is:
CFO + interest (net of taxes) – investment in fixed capital.
This is the cash flow from operations that you can use for whatever you want: pay off your creditors (note: you do some of that: you pay interest out of this cash flow), pay dividends, buy a casino in Vegas, whatever.
(Technically, the FCInv should be the fixed capital investment that the firm needs to make to maintain its current capacity – renovating buildings, replacing worn-out machinery, and so on – but not investment to expand (or contract) capacity. In practice, it’s difficult to separate those two, so we just use all FCInv.)
In the other thread you had mentioned that you need to remove all non-cash and non-operations related charges to generate the FCFF value. In this sense, wages payable should be added back to net income to generate CFO, which in turn is used to obtain FCFF (or directly to obtain FCFF from net income). Here, the wages payable added is the wages payable for the current year/period. Two questions related to this: 1) Regarding FCFF you also said “This is the cash flow from operations that you can use for whatever you want”. Now the wages payable is a very real obligation that must be satisfied. However, since we added back the wages payable, we are essentially saying that “in spite of this real obligation to your employees, you can use the FCFF cash as you please”. Please explain to me why this is. My example above to which Asuka replied to somewhat answers this question. In his answer, he didn’t add the $5000 or $6000. He simply subtracted the different between the years - the WCInv value. However, I don’t see how that is consistent with your statement where you said that we should remove all non-cash charges. 2) Depending on the answer to (1), what is the relationship between adding back wages payable and subtracting the “change in wages payable” through the WCInv measure? The wages payable obviously refers to wages payable (duh). Also, WCInv also references the wages payable - but both this year and of last year.
Thanks Asuka. As I discussed above, I don’t understand how your calculation is consistent with what S2000magician said about reversing all non-cash charges. While I appreciate the statement that FCFF is the cash flow from operations that you can use for “whatever you want”, I am still trying to understand that phrase in the context of all these charges that we are reversing. In a nutshell, I am not understandnig how you can do “whatever” with the money, when we reverse/add back current liability charges (e.g. wages payable) which must be paid to employees by law - you didn’t do this here, but S2000magician said that we SHOULD reverse all non-cash charges. Stated another way, I am not appreciating the “point of it all” if you will - or the significance of the calculated value in the context of all the outstanding liabilities that are present. Thank you both.
Cash flow is the change in cash _ for the year _. When I said to remove all noncash charges, I meant that in the same sense: _ for the year _; if wages payable increased during the year, then you add back the _ increase _ (not the total balance). My apologies for not making that clear.
You mention that wages payable is an obligation . . . well, so are coiupon payments on bonds. You add them back in because that’s cash you have available to do with as you please. It’s probably a good idea if “as you please” includes paying your obligations (to continue as an ongoing concern), but there’s still some discretion (e.g., you could wait and pay those obligations next year, instead using the cash for that casino opportunity that won’t be around next year).
Similarly for FCFE: you add in net borrowing. That’s cash that you could pay to your shareholders if you want to. It’s probably a stupid idea – presumably you borrowed the money to invest it in the business – but you could do it if you wanted to.
Thanks S2000magician. Ok, that makes more sense to me.
Now, the change in working capital = WCInv
= (this year current assets - this year current liabilities) - (last year current assets - last year current liabilities)
= (this year current assets - last year current assets) - (this year current liabilities - last year current liabilities)
The above quantities can contain both cash and do contain the wages payable as well. If we subtract WCInv as above from NI and also “reverse the delta in wages payable” there will be double counting. How should this be done with respect to 1) cash being in the net working capital and 2) possible double counting with respect to wages payable being adjusted through net working capital and through an individual adjustment of “eliminating all non-cash (delta) charges”.
They do not include cash. These adjustments are trying to reconcile net income to CFO – and, finally, to total cash flow. If you include the change in cash . . . well, if you already have the change in cash you don’t have to do much to get to the change in cash.
These are your operating accounts: A/R, inventory, prepaid expenses, wages payable, accounts payable, unearned income. Not cash. _ Not dividends payable. _
The delta in wages payable doesn’t fall under the rubric of “noncash charges”. That category mean things like depreciation, amortization, accretion, and depletion: fixed asset stuff, not working capital stuff. You make the adjustment to wages payable (and A/P, and A/R, and so on) under the “changes in net working capital” heading.
S2000magician’s eplanations are spot on. At the risk of muddying the waters, here’s aperspective that you might find helpful - if not, file 13 the sucker.
FCFF is the cash you have available “To do whatever you want with” - pay out to stockholders/bondholders or invest in “Stuff” - either working capital, long-term assets, or cash.
The reason we have to do this dance is that we’re starting with a number (Net income) that is based on accrual accounting. And in this system, profit isn’t cash - we have some revenues (i.e. sales made on credit, resulting in an increase in Accounts receivables) and expenses that aren’t cash (like inventory purchased on credit - A/P). We also have things like “paper” gains on a sale and depreciation that aren;t cash. Likewise, we have outlays or inflows of cash that don;t show up in Net Income ( like an investment in or sale of a fixed assets).
That’s where the statement of cash flows (CFO) and FCFF come in. Think of all these adjustments as:
“De-accrualizing” (that’s not a real term, just my attempt at getting a handle on the concept) Net Income - that’s where we adjust for all the Net Working Capital Changes. We could subtract all the increases in operating current assets (i.e. an increase in inventory is an outflow that’s not reflected in Net Income, so we deduct it) and add back all the increases in operating current liabilities. This part is equivalent to subtracting the CHANGE in NWC. And since the biggest “Accrual” divergence is depreciation, we add that back too (it’s a non-cash deduction to NEt Income).
This first step is essentially what you get from CFO. If you were on a cash basis and didn’t have any interest epense, our Net Income would be your FCFF. If you do have interest epense, you have to add back the after-tax amount.
Since we’ve taken care of the “non-cash stuff” that’s not reflected in Net Income, we now have to take care of the CASH inflows and outflows. That’s where we add back the investment in Fixed Assets. A purchase of PPE doesn’t show up in Net Income, so the Net Income is “off” (doesn;t reflect available cash flow) by the amount of what we bought (i.e. the change in Gross Fied Assets, or equivalently the change in Net Fixed Assets plus the Depreciation Epense).
It’s a long-winded explanation. But to recap, all you’re doing is adjusting Net Income back to what it would be if you were on a “Cash Basis”. Once you see this, a lot of the little things fall out. For example, if you have a gain on a sale of property, it’'s not cash, but it does increase Net Income. So, you’d subtract it to adjust the Net Income downward to reflect what artifically inflates it (relative to what it would be on a cash basis).
So, S2000magician, would you please confirm following ?
The “Working Capital” here shall refer to : Current Assets (excluding “cash and cash equivalent”) - Current liability (excluding short term liabilities from investing and financing activities, like “dividend payble”)
The gain/loss from sales of fixed assets is excluded (deducted) from net income because it has been accounted for in FCInv.
Asuka - While S2000 magician would probably say it more cleanly, I’ll give it a shot: #1 is correct. But while you do net out the gain/loss from sale of FA (#2), the reason you do it is not “because if has been accounted for in FCINV” (i.e. the change in Gross FA). It’s because you are trying to calculate “Cash flow” by putting Net Income back to a cash basis. So you are adding back non cash epenses (like Depreciation) and deducting non-cash income (like the gain).
Thanks again. PS: I could just memorize the two formulas - but this inconsistency in my understanding of these alternative formulations is really bugging me… 
Ok, so what I am going to gather from all these formulas and your responses is that – DON’T necessarily depend on these formulas and just understand the general concept. The reason I say that is b/c if formulas have omissions/assumptions that may not be generally justified, I don’t see a point in getting too caught up in any particular formulation. So I think it’s better if I direct my questions to the general notion of FCFF. You said earlier that “FCFF means cash available to the firm, for whatever use the firm deems appropriate, foreseen or not.”. With that definition, I’ll describe my current (somewhat limited) understanding. Hopefully it’s on the right track! Here goes… There are 3 cash flow classifications: 1) CFO, 2) CFI (investing activites), and 3) CFF (financing activities). Here, CFO + CFI + CFF = CHANGE in cash balance. Therefore, the cash flow calculations are NOT about the total cash balance, but about delta in cash balance for that particular operating cycle. Therefore, the FCFF calculation, which is based on CFO or net income (depending on formulation) is also a “delta measure”. In the sense that it is not the TOTAL cash that is available - but a “change” in the “cash availale to the firm” - a sort of a “gain in liquidity” if you will. So, an extremely wealthy company with a lot of cash sitting in a chequing account (for whatever reason) can still have a negative FCFF if they have a bad year (or quarter). As discussed earlier, two popular formulations of FCFF are based on net income and CFO as base values. Therefore, it appears that what the company does with investing activities (except for fixed capital investment) and financial activities are not relevant. So conceivably, if a fruit company uses all of its cash in the books (including all the new positive operating cash flow in the current period) to buy a Casino in Vegas (for some odd reason) as an investing property, the FCFF will NOT catch that. So, even though in “reality” all the cash is completely tied down and there is no liquidity, FCFF can still show some positive value. In calculating FCFF, when we use net income as the base, we subtract increases in NON-CASH asset accounts (e.g. accounts receivable) and add increases in NON-CASH liability accounts (e.g. wages payable). So, even if a company by law is required to spend all of its cash (existing cash and new operating cash flow) to pay its employees for wages, FCFF will NOT recognize this lack of choice and may indicate a high FCFF value - even though after paying the wages, it may not have any cash “to do as it pleases”. Moreover, we subtract FCinv from this b/c that capital investment is required to keep the company running. Here, I am presuming this is the ADDITIONAL FCinv that is required compared to the PREVIOUS period (i.e. the delta FCinv compared to previous year’s fixed capital). The fixed capital being things like a factory. the reason I thought this is a delta measure is b/c, otherwise, if a company has a huge factory that is very expensive, that would nullify any positive value in the FCFF calculation when we subtract the “value” of the factory. Now, if I am right about the above, WCInv is the big one that’s giving me some trouble conceptually. Asuka wrote (to which you agreed to) that “If I am not wrong, WCinv shall be the difference between the working capital of this year and the working capital of last year.”. Wages payable discussed above (which we add to net income to calculate FCFF) is part of current liabilities. Given WCInv is talking about the delta between working capital of this year and last year, I am unsure what WCInv is referring to. Lets say the ONLY current liability that is present is wages payable and last year it was $5000 and this year it was $6000. Lets also say that current assets (all cash) was $10K in both years. I am presuming we add $6000 to nullify wages payable and subtract $1000 to remove WCInv. But, I am not understanding the reason for this treatment. Can you please tell me the correct treatment of this in calculating FCFF? The correct numbers will hopefully help me understand exactly what we are doing and more importantly, WHAT we are trying to achieve by calculating FCFF - given all the caveats which I (hopefully correctly) identified above. I have more questions, but I thought it would be better to see if my understanding is correct up to this point. As always, thanks very much S2000magician!