[1] It is that portion of cash flow that can be extracted from a company and distributed to creditors and securities holders without causing issues in its operations.
Free cash flow may be different from net income, as free cash flow takes into account the purchase of capital goods and changes in working capital and excludes non-cash items.
Typically, in a growing company with a 30-day collection period for receivables, a 30-day payment period for purchases, and a weekly payroll, it will require more working capital to finance the labor and profit components embedded in the growing receivables balance.
Net free cash flow = Operation cash flow − Capital expenses to keep current level of operation − dividends − Current portion of long term debt − Depreciation Here, capex definition should not include additional investment on new equipment.
Depreciation should be taken out since this will account for future investment for replacing the current property, plant and equipment (PPE).
FCF measures: In symbols: where Investment is simply the net increase (decrease) in the firm's capital, from the end of one period to the end of the next period: where Kt represents the firm's invested capital at the end of period t. Increases in non-cash current assets may, or may not be deducted, depending on whether they are considered to be maintaining the status quo, or to be investments for growth.
It is also preferred over the levered cash flow when conducting analyses to test the impact of different capital structures on the company.
[3] Investment bankers compute free cash flow using the following formulae: FCFF = After tax operating income + Noncash charges (such as D&A) − CAPEX − Working capital expenditures = Free cash flow to firm (FCFF) FCFE = Net income + Noncash charges (such as D&A) − CAPEX − Change in non-cash working capital + Net borrowing = Free cash flow to equity (FCFE) Or simply: FCFE = FCFF + Net borrowing − Interest*(1−t) Free cash flow can be broken into its expected and unexpected components when evaluating firm performance.
In a 1986 paper in the American Economic Review, Michael Jensen noted that free cash flows allowed firms' managers to finance projects earning low returns which, therefore, might not be funded by the equity or bond markets.
Consistent with the agency costs of free cash flow, management did not pay out the excess resources to shareholders.
Instead, the industry continued to spend heavily on [exploration and development] activity even though average returns were below the cost of capital.