Free cash flow (FCF) is the amount of cash available to investors after assets investments are made. In other words, FCF can be defined as net operating profit after taxes (NOPAT) less change in net working capital and change in fixed assets. It is a very useful metric for investors because it shows how much cash can be extracted from a business without damaging its operations.
There are many approaches to calculate free cash flow depending on the required accuracy of the appraisal. The most precise appraisal can be given using the following approach:
FCF = NOPAT – Change in Invested Capital
where NOPAT is net operating profit after taxes, and change in invested capital is the difference between the amount of invested capital at the end of the period and the amount of invested capital at the beginning of the period. See here how to calculate NOPAT, and follow these guidelines to calculate invested capital!
If a rough appraisal of free cash flow is needed, the following formula can be used:
FCF = NOPAT – Change in Net Working Capital – Change in Fixed Assets
where change in net working capital is the difference between the amount of net working capital at the end of the period and the amount of net working capital at the beginning of the period. Change in fixed assets is the difference between the amount of fixed assets at the end of the period and the amount of fixed assets at the beginning of the period.
In turn, net working capital can be calculated as follows:
Net Working Capital = Current Assets – NIBCLs
where NIBCLs are noninterest-bearing current liabilities (e.g., accounts payable and accrual liabilities).
The formula of free cash flow above can be modified as follows:
FCF = EBIT × (1 – Tax Rate) – Change in Net Working Capital + DA – CAPEX
where DA is depreciation and amortization, and CAPEX is capital expenditures.
Free cash flow calculation example
XYZ Company reported the following financial results for the last year:
Balance sheet, US $ in thousands
Income statement, US $ in thousands
As mentioned above, free cash flow is the difference between NOPAT and the change in invested capital.
To get the exact invested capital number, we need to sum current assets less NIBCLs (accounts payable, accrual liabilities, advances received, and accrued taxes payable) and noncurrent assets (property, plant and equipment, and other noncurrent assets). This number should be adjusted by subtracting the amount of deferred tax liabilities.
Invested capital as of December 31 2014= $14,610,000 – ($3,100,000 + $660,000 + $50,000 + $700,000) + $26,500,000 + $4,760,000 – $230,000 = $41,130,000
Invested capital as of December 31 2015 = $15,710,000 – ($2,900,000 + $570,000 + $110,000 + $630,000) + $28,000,000 + $5,120,000 – $370,000 = $44,250,000
Thus, the change in invested capital is +$3,120,000.
As far as EBIT (also known as operating income) is disclosed in the income statement, the following series of adjustments should be made to get the exact NOPAT number:
- add back the change in allowance of doubtful accounts of $24,000 ($140,000 – $116,000)
- subtract the difference in deferred tax liabilities of $140,000 ($370,000 – $230,000)
- subtract the declared provision for taxes of $1,797,000
NOPAT = $7,710,000 + $24,000 – $140,000 – $1,797,000 = $5,797,000
So, the free cash flow of the Company is $2,677,000.
FCF = $5,797,000 – $3,120,000 = $2,677,000