Everything about Free cash Flow Simplified! What we will …

What is Free Cash Flow?

Free cash flow means the cash that is left over after a company pays for its operating expenses and capital expenditures (Capex) like purchasing new machinery, equipment, land & building, etc. and satisfying all its working capital needs.

In simple words, suppose whatever cash that is left with you after you spend your salary or income is known as Free cash flow that you can use for different purposes.

The more FCF a company has, the better it is. Businesses which generate high FCF can:-

1⃣Give investors higher dividends
2⃣Do share buybacks
3⃣Build a war chest for acquisitions or Capex.
4⃣Reinvest in the business when opportunity arises with lesser dependence on debt.

How to calculate Free Cash Flow👇:

To calculate free cash flow, all you need to do is open the Cash Flow Statement and subtract "Net Capital expenditure" from "net cash from operating activities".

The formula looks like this:

Free cash flow = Net cash from operating activities-Net Capex

Let’s calculate the FCF for Happiest Minds for FY 2021-22:

As we can see from the financials its cash flow from operating activities is 168 cr and its net capital expenditure is = 67Lakhs+3.46cr-(10Lakhs)

=168 Cr-4.03 crores= 163.97 crores is the FCF!

Now, let's look at two types of Free cash flow!

1⃣Free cash flow to Firm

2⃣Free cash flow to Equity

Free Cash Flow to the Firm (FCFF):

FCFF is the same FCF which we have discussed above, FCFF means the ability of the business to produce cash after deducting all its capital expenditures which is calculated as CFO - Capex.

Thus, the free cash flow that is left to the Firm

Free Cash Flow to the Equity (FCFE):

Free cash flow to equity (FCFE) is the amount of cash a business generates that is available to be distributed to the company’s equity shareholders as dividends or stock buybacks after all expenses, reinvestments, and debt repayments.

It is also known as Levered Free Cash Flow.

It is calculated as follows:

FCFE = Cash from Operating Activities – Capital Expenditures + Net Debt Issued (Proceeds from borrowings-Repayment of borrowings)

Free Cash Flow to firm vs Free Cash Flow to Equity:-

The main difference between the two is that Free cash flow to firm represents the Cash flow that is available to both the Debt and Equity holders.

FCFE only represents the cash flow that is available to the shareholders!

The Importance of Free Cash Flow ⤵️

Company with high free cash flow can expand, develop new products, have a safety cushion, be in control of its own destiny, can expand without debt and pay dividends etc. Positive free cash flow is indicative of overall business health.

We can check it from the financials of TCS as well, where it is generating high free cash flow because its business is asset light where it doesn’t require high Capex. So they are returning this FCF to shareholders via share buyback and dividends.

This is the 10 year cumulative Cash flow statement of TCS. Just look at dividend paid 🤯🤯

Out of 2.25 Lakh crores of Cumulative Cash flows generated by TCS, they have paid almost 1.4 Lakh crores of dividend in the last decade. As the business can grow without Capex.
@Tijori1

What are the limitations of Free cash flow?

Low free cash flow is not always indicative of a failing business. Even healthy companies see a dip in free cash flow when they're actively doing Capex for pursuing growth.

Businesses which are into manufacturing or in other areas have to Spend on Capacity expansion in order to grow.

We can see the same from some examples where companies were doing high capex to leverage growth resulting in negative free cash flow for a few years ⤵️⤵️

For Example:- Deepak Nitrite Ltd was going through high Capex phase between FY2017 to 2020, during this time they were setting up a Phenol plant resulting in negative free cash flow during this period.

(Credits @Tijori1 )

Even in Laurus Labs case the company has spent nearly 81% of the cash flows it has generated in Capex over the last 5 years, thereby resulting in lower free cash flows but super fast Earnings growth:

Finally, lets learn an extremely important concept.

Linking the concept of change in working capital and its impact on Free Cash Flow. Those who understand can make a killing if they see working capital improving in a company.

Example:- APL Apollo

In FY 2020 they switched to a cash and carry model from normal credit period business of 20 days which resulted in the reduction in net working capital days from 25 to 8 in FY 2021.

Just look at the working capital days:-

Improvement in working capital led to two major changes:-

1. Massive deleveraging as lesser working capital loans were required to run the business.

2. Generation of solid free cash flow that can be paid out dividends or be used for Capacity expansion through internal accruals.

Let's look at peers within the sae industry and how generation of Free Cash Flow is impacting the valuations of all these companies.

If we look at the 10 Years cumulative cash flow of the companies, it is as follows:

Look at the Working capital and this where Page wins!!

If you loved the thread and understood the concept of Free cash flow, then retweet to educate maximum investors.

Thank you for reading!

Apart from this, I am doing a detailed Webinar on Valuations on 22nd of May in which I will discuss multiple ways to value a business with detailed case studies :)

Link to register 🔗: https://t.co/fTr7JYgszn