What is the concept of free cash flow as applied to organization? Explain the process of computation.
We define net cash flow as net income plus non cash adjustment which typically means net income plus depreciation though that cash flows cannot be maintained over time unless depreciated fixed assets are replaced.So management is not completely free to use its cash flows however it chooses. Therefore we define the term free cash flows.Free cash flow is the cash flow actually available for distribution to investor after the company has made all the investment in fixed assets and working capital necessary to sustain ongoing operation. When we studied income statement in accounting the emphasis was probably on the firm’s net income, which is accounting profit.However the value of company’s operation is determined by the stream of cash flows that the operations will generate now and in the future. To be more specific, the value of operation depends on all the future expected free cash flows, defined as after- tax operating profit minus the amount of new investment in working capital and fixed assets necessary to sustain the business. Therefore the way for managers to make their companies more valuable is to increase their free cash flow.
Uses of FCF:
1.Pay interest to debt holders, keeping in mind that the net cost to the company is the after tax interest expense.
2.Repay debt holders, that is, pay off some of debt.
3.Pay dividends to shareholders.
4.Repurchase stock from shareholders.
5.Buy marketable securities or other non operating assets.In practice, most companies combine these five uses in such a way that the net total is equal to FCF. For example, a company might pay interest and dividends, issue new debts, also sell some of its marketable securities. Some of these activities are cash outflows (paying interest and dividends) and some are cash inflows(issuing debt and selling marketable securities), but the net cash flow from these five activities is equal to free statement of cash flow.
Computation of free cash flows:
Eg:
Suppose the company had a 2001 NOPAT of $170.3million and depreciation is only the non cash charge which is $100million then its operating cash flow in 2001 would be NOPAT plus any non cash adjustment on the statement of cash flows.
2. Operating cash flow =NOPAT +depreciation (non cash adjustment)
= $17.03 + $100
= $270.3
Company has $1,455million operating assets, at the end of 2000, but $1,800 at the end of 2001.it made a netinvestment in operating assets of
Net investment in operating assets = $18, 00 - $1,455
= $345million
If net fixed assets rose from $870million to $1000million however company reported $100million of depreciation. So its gross investment in fixed assets would be
Gross investment = net investment + depreciation
= $130 + $100
= $230million
Company free cash flows in 2001 was
FCF = operating cash flow – gross investment in operating assets
= $270.3 - $445
= - $174.7million
An algebraically equivalent equation is
FCF = NOPAT - Net investment in operating assets
= $170.3- $345
= - $174.7million
Even though company had a positive NOPAT, its very high investment in operating assets resulted in anegative free cash flow. Because free cash flow is what is available for distribution to investor, not only wasthere nothing for investors, but investor actually had to provide additional money to keep the business ongoing.A negative current FCF not necessarily bad provided it is due to the high growth or to support the growth. Thereis nothing wrong with profitable growth; even it causes negative free cash flow in the short term
