In this article, I will show you how to calculate and interpret free cash flow to the firm (FCFF), also known as unlevered free cash flow (UFCF). Understanding FCFF is essential for investors as it provides insight into a company's financial health, revealing the cash available to debt holders, preferred, and common stockholders after covering operating expenses, non-cash expenses like depreciation and amortization, capital expenditures, and changes in non-cash net working capital. It's useful for analyzing past performance, comparing companies, and for valuations, especially for projecting future cash flows in discounted cash flow (DCF) models.
This article will explain FCFF, describe its differences from free cash flow to equity (FCFE), present three alternative formulas for calculating FCFF, and provide a real-world example of calculating and interpreting FCFF.
Free Cash Flow to the Firm (FCFF) Explained
Free cash flow to the firm (FCFF) is the cash flow available to all funding providers (debt holders, preferred stockholders, and common stockholders) after covering operating expenses, including depreciation and amortization (D&A), and investments in capital expenditures (CapEx) and non-cash net working capital (NWC). Since FCFF represents cash flows to all claimants in a firm, not just equity holders like free cash flow to equity (FCFE), it's also known as unlevered free cash flow (UFCF).
FCFF is fundamental for valuations, particularly the discounted cash flow (DCF) model, which assesses a business's intrinsic value by forecasting unlevered free cash flows, then discounting them back using the "weighted average cost of capital" (WACC). This rate reflects the company's full capital structure, incorporating the time value of money to yield an enterprise value. Adding cash and short-term investments, and subtracting total debt and minority interest from this figure, reveals the equity value attributable to shareholders, from which an implied valuation can be derived.
Thus, because FCFF reveals the true cash-generating ability of a company's core business, disregarding how it finances its operations (with debt, preferred stock, and/or equity), it provides a clear picture of how much cash is left for all funding providers after paying for necessary expenses and investments. This makes FCFF an important indicator for assessing a firm's valuation, performance, and financial strength.
Free Cash Flow to the Firm (FCFF) vs. Free Cash Flow to Equity (FCFE)
When considering a firm's financing options, it can raise capital primarily through equity investors or debt, a choice available to both private and public entities. This leads to two primary categories of free cash flow: free cash flow to the firm (FCFF) and free cash flow to equity (FCFE).
FCFF, or unlevered free cash flow (UFCF), represents the total cash flows available to both equity investors and lenders. It includes cash from operations after covering operating expenses and investments, but before any debt payments. This measure provides a comprehensive view of the cash generated by the firm's core operations available for expansion, debt repayment, or distributions to shareholders, without the impact of debt financing.
In contrast, FCFE, also known as levered free cash flow (LFCF), is the cash flow available to equity shareholders after all financial obligations, including debt payments, have been met. It signifies the residual cash flow that equity investors can claim from the firm, factoring in debt obligations by considering interest expenses and net debt changes.
The main difference between FCFF and FCFE lies in their treatment of debt. FCFF offers a broader perspective by excluding debt impact, while FCFE provides a more focused view by accounting for debt payments and borrowings. To derive FCFF from FCFE, the formula can be adjusted as follows:
FCFF = FCFE + Interest Expenses × (1 - Tax Rate) - Net Borrowing
This formula adjusts FCFE (cash exclusively available to equity shareholders) by adding after-tax interest (indicating cash outflow to debt holders) and subtracting net borrowing (reflecting reduced cash from new debt or extra cash from debt repayments). This results in FCFF, the cash flow available before debt payments, offering a comprehensive view of the cash available to all capital providers.
How to Calculate Free Cash Flow to the Firm (FCFF)
This section discusses the standard free cash flow to the firm (FCFF) formula and explains its formula components in-depth.
Free Cash Flow to the Firm (FCFF) Formula
The EBIT to FCFF formula is shown below:
FCFF = NOPAT + D&A - CapEx - Change in Non-Cash NWC
where:
- FCFF = free cash flow to the firm (aka unlevered free cash flow (UFCF))
- NOPAT = net operating profit after tax (aka EBIAT (earnings before interest after taxes)); where NOPAT = EBIT × (1 - Tax Rate)
- D&A = depreciation and amortization
- CapEx = capital expenditures
- Change in Non-Cash NWC = change in non-cash net working capital
EBIT to FCFF Formula Explanation
There are multiple methods investors can use to calculate free cash flow to the firm (FCFF). However, the most conventional method begins with the company's operating income, or EBIT (earnings before interest and taxes), which is an unlevered profit measure unaffected by interest expenses, thus representing earnings before the cost of debt financing.
To account for taxes in a manner reflecting the firm's operations without interest expenses, taxes are applied to EBIT as if no interest were paid, leading to a hypothetical after-tax operating income. The tax rate can be calculated as the total tax expense divided by the taxable income (i.e., the earnings before tax (EBT)), and can also be found in the company's financial statements or tax filings. This results in what McKinsey terms as "NOPAT" (net operating profit after taxes), also called "EBIAT" (earnings before interest after taxes).
The NOPAT formula calculation is shown below:
NOPAT = EBIT × (1 - Tax Rate)
where:
- NOPAT = net operating profit after tax (aka EBIAT (earnings before interest after taxes))
- EBIT = earnings before interest and taxes
- Tax Rate = effective tax rate applied to company's taxable income (income tax expense / earnings before tax (EBT))
Following the NOPAT calculation, non-cash charges, primarily depreciation and amortization (D&A), are added back to NOPAT because they represent non-cash expenses that reduce taxable income but do not affect the company's actual cash flow.
Next, the calculation requires subtracting capital expenditures (CapEx), which are essential for maintaining or expanding the firm's operations. This step accounts for the cash spent on investments critical to the firm’s sustainability and future growth.
Finally, the calculation adjusts for changes in net working capital (NWC), which reflect the cash effects of handling short-term assets and liabilities. It specifically targets changes in non-cash NWC within the FCFF formula to evaluate how the company utilizes non-cash assets in supporting its operations and covering short-term obligations.
The adjustment for changes in net working capital (NWC) is crucial in calculating free cash flow to the firm (FCFF), as it reflects the cash implications of managing short-term assets and liabilities. Specifically, the focus on non-cash NWC changes within the FCFF formula evaluates the company’s utilization of non-cash assets for operational funding and covering short-term debts.
Here's how an increase/decrease in NWC can be interpreted:
- Increase in Non-Cash NWC: Suggests the company is channeling more cash into immediate operational requirements, such as inventory or receivables, leading to less cash available for both debt and equity holders. This indicates the company's operational cash is being invested in supporting the day-to-day running of the business, rather than being free for servicing debt or distributing to shareholders.
- Decrease in Non-Cash NWC: Signals that the company is releasing cash tied up in operations, perhaps through more effective management of inventory and receivables or by increasing its payables. This results in more cash being available in the FCFF calculation, as the company requires less cash to manage its short-term operational needs, making additional funds available for expansion, debt repayment, or shareholder distributions.
For instance, an increase in current operating assets, such as accounts receivable (AR), suggests less efficiency in collecting cash from credit sales, thereby reducing available cash. On the other hand, an increase in current operating liabilities, like accounts payable (AP), indicates delayed payments to suppliers/vendors, which temporarily retains cash within the company.
Alternative Free Cash Flow to the Firm (FCFF) Formulas
The three alternative FCFF formulas in this section, EBITDA to FCFF, Net Income to FCFF, and CFO to FCFF, provide diverse perspectives and methodologies for assessing a company's free cash flow, catering to various financial analysis needs and data availability. Understanding these formulas is important as they offer nuanced insights into a company's ability to generate cash available to all capital providers.
EBITDA to FCFF Formula
The EBITDA to FCFF formula provides an approach to calculate a firm's free cash flow, directly from its operational profitability.
The EBITDA to FCFF formula is shown below:
FCFF = EBITDA × (1 - Tax Rate) + (D&A × Tax Rate) - CapEx - Change in Non-Cash NWC
where:
- FCFF = free cash flow to the firm (aka unlevered free cash flow (UFCF))
- EBITDA = earnings before interest, taxes, depreciation, and amortization
- Tax Rate = effective tax rate applied to company's taxable income (income tax expense / earnings before tax (EBT))
- D&A = depreciation and amortization
- CapEx = capital expenditures
- Change in Non-Cash NWC = change in non-cash net working capital
The formula starts with EBITDA, subtracts taxes to reflect net operating profit after taxes, adds back the tax shield on D&A (since these are non-cash charges), and then deducts CapEx and the change in NWC to account for the cash used in investing in and managing the company's operations and working capital.
This method is advantageous as it begins with EBITDA, offering a clear view of operational cash flows before the impact of financial structure, taxes, and non-cash accounting items. It simplifies the analysis for companies with significant non-cash expenses and provides a more direct estimate of cash flows from operations.
However, this approach has its limitations. Particularly, it may overestimate free cash flow for firms with large capital expenditures or significant changes in working capital, as it does not directly account for these cash flows in the initial EBITDA figure. It's also important to consider all non-cash expenses, not just D&A, as the formula suggests.
Net Income to FCFF Formula
The Net Income to FCFF formula offers a direct method for converting a firm's net income into FCFF, providing insight into the cash available to all capital providers after accounting for all expenses, including taxes and interest.
The net income to FCFF formula is shown below:
FCFF = Net Income + D&A + Interest Expense × (1 - Tax Rate) - CapEx - Change in Non-Cash NWC
where:
- FCFF = free cash flow to the firm (aka unlevered free cash flow (UFCF))
- Net Income = profit a company has left after all expenses, taxes, and interest charges have been deducted from total revenue
- D&A = depreciation and amortization
- Interest Expense = cost incurred by a company due to borrowed funds
- Tax Rate = effective tax rate applied to company's taxable income (income tax expense / earnings before tax (EBT))
- CapEx = capital expenditures
- Change in Non-Cash NWC = change in non-cash net working capital
This formula starts with net income, reflecting the company's earnings after all expenses. It adds back D&A to adjust for non-cash charges and includes the after-tax effect of interest expense to focus on operational cash flows before financing costs. CapEx and changes in NWC are then subtracted to account for fixed asset investments and working capital adjustments.
The method translates net income to actual cash flow, providing a straightforward way to analyze a firm's cash generation beyond reported earnings. Adjustments for D&A and changes in NWC also resemble the cash flow from operations calculation, offering insights into operational liquidity. The addition of interest expense, after adjusting for taxes, considers the tax benefits derived from debt financing, aiming to present a view of cash flows that is independent of the company’s financing structure.
However, this formula may not capture all nuances of a company's operational cash flows, especially for firms with significant financing activities or investments. The dependence on net income might also mask real cash flows due to accounting conventions and non-cash expenses.
Cash From Operations (CFO) to FCFF Formula
The Cash From Operations (CFO) to FCFF formula provides a straightforward method for estimating the FCFF directly from its operational cash flows. This approach simplifies the calculation of FCFF, focusing on cash generated by the company's operations before financing and investing activities are considered.
The CFO to FCFF formula is shown below:
FCFF = CFO + Interest Expense × (1 - Tax Rate) - CapEx
where:
- FCFF = free cash flow to the firm (aka unlevered free cash flow (UFCF))
- CFO = cash from operations
- Interest Expense = cost incurred by a company due to borrowed funds
- Tax Rate = effective tax rate applied to company's taxable income (income tax expense / earnings before tax (EBT))
- CapEx = capital expenditures
The formula begins with CFO, capturing cash from core business operations, and adds back the after-tax interest expense to reflect tax savings from debt financing while separating operational cash flow from financing costs. It then subtracts CapEx, addressing the cash used for physical asset acquisitions or upgrades, to determine the free cash flow available to all capital providers.
Because CFO inherently adjusts for non-cash expenses (like D&A), and changes in NWC, this negates the need for their inclusion in the formula, unlike previous FCFF calculation methods. However, since CapEx falls under investing activities and isn't included in CFO, its subtraction is still required.
This method's simplicity and focus on operational cash flows are key advantages, offering insights into cash generation from operations, net of debt financing costs and physical asset investments. It's especially beneficial for investors assessing cash generation capability post-capital expenditures.
However, this formula presumes that CFO accurately reflects all necessary adjustments for a comprehensive free cash flow view, which may not always hold true. Therefore, it's important not to take the CFO figure at face value without verifying that non-cash charges are genuinely related to core operations and are recurrent.
Free Cash Flow to the Firm (FCFF) Examples
In this section, we'll demonstrate how to calculate free cash flow to the firm (FCFF) for Microsoft (MSFT), a global technology leader known for its software, services, devices, and solutions. We'll show the calculation for the conventional FCFF formula and compare it with the alternative FCFF formulas discussed above for the company's 2023 fiscal year (FY).
FCFF From Operating Income (EBIT) Example
To begin the conventional EBIT to FCFF calculation, we need to obtain the company's income statement and cash flow statement either from the investor relations section of its website or from the SEC's website, using the most recent 10-K annual report.
You can download the file below, which presents Microsoft's income statement, balance sheet, and cash flow statement in a formatted manner, alongside the FCFF calculation models discussed in this article:
NOPAT
To calculate FCFF, begin by calculating NOPAT (aka EBIAT), using the formula below, as a reminder:
NOPAT = EBIT × (1 - Tax Rate)
Microsoft's operating income (EBIT) for FY 2023 is $88,523M, which can also be calculated by subtracting all the operating expenses from the company's gross profit. The company's effective tax rate, as reported under the "Notes to Financial Statements" section in its 10-K annual report, is 19.0%. This rate can also be calculated by dividing the total income tax by taxable income (i.e., earnings before taxes (EBT)), which also results in an effective tax rate of 19.0% ($16,950M / $89,311M). In either case, Microsoft's after-tax operating income is calculated as follows:
NOPAT [MSFT] = $88,523M × (1 - 0.19)) --> $71,723M
Thus, Microsoft's NOPAT in FY 2023 is $71,723M.
Non-Cash Expenses
The next part of the FCFF calculation requires locating depreciation and amortization (D&A), the change in net working capital (NWC), and capital expenditures (CapEx), as shown in the FCFF formula:
FCFF = NOPAT + D&A - CapEx - Change in Non-Cash NWC
Begin by adding back any non-cash expenses Microsoft incurred in FY 2023 to NOPAT, not just D&A as the standard FCFF formula states, because all non-cash expenses reduce taxable income without affecting the company's actual cash flow. To do this, examine the company's cash flow statement, specifically the adjustments to reconcile net income to net cash from operations, as shown below for Microsoft:
Here, D&A for FY 2023 is $13,861M. Other "non-cash" items include stock-based compensation, non-cash losses (gains), and deferred income taxes. These other non-cash items are added back to NOPAT, except for stock-based compensation. Although typically listed in the non-cash section of a cash flow statement, stock-based compensation is considered more of an "in-kind expense" rather than a standard non-cash expense.
This distinction is made because stock-based compensation, reflecting the cost of equity financing, uniquely impacts shareholder value, setting it apart from other non-cash adjustments. Thus, it should be excluded from the FCFF calculation. As a result, the total of these relevant non-cash items is $7,998M ($13,861M (D&A) + 196M (Non-Cash Losses (Gains)) - $6,059M (Deferred Income Taxes)).
Changes in Non-Cash Net Working Capital (NWC)
Examining items below these non-cash expenses and stock-based compensation reveals net working capital (NWC) changes, as outlined below:
Summing the changes in NWC for FY 2023 leads to a decrease of -$2,388M. This decrease in NWC increases cash flows because it signifies that less cash is tied up in the company's day-to-day operations, increasing liquidity.
However, for a more accurate FCFF calculation, focus on non-cash NWC instead of just NWC. This approach excludes long-term assets and liabilities, providing a clearer view of the cash generated by core operations. For Microsoft, the non-cash NWC adjustment for FY 2023 is -$108M (-2,388M (Changes in WC) - $553M (Other LT Liabilities) - $2,833M (Other LT Assets)), more accurately reflecting operational liquidity, free from the effects of financing activities and long-term investment decisions.
Capital Expenditures (CapEx)
The final step in the FCFF calculation is subtracting CapEx (aka Plant, Property, and Equipment (PP&E)), listed under "Investing Activities" on the cash flow statement:
Microsoft's FY 2023 CapEx is -$28,107M. Including acquisitions (-$1,670M for FY 2023) in the CapEx calculation results in a total outflow of -$29,777M (-$28,107M + -$1,670M).
Notably, acquisitions are included in this FCFF calculation because they represent cash outflows impacting FCFF directly, important for assessing the firm's operational capacity and/or strategic positioning. Conversely, investments like purchases, maturities, and sales are excluded from CapEx, as they relate more to financing decisions, thus focusing the analysis on operational cash flows.
Calculate EBIT to FCFF
With all components identified for FY 2023, Microsoft's FCFF calculation is as follows:
FCFF [MSFT] = $71,723M + $7,998M - $29,777M + $108M --> $50,052M
Therefore, Microsoft's FCFF for FY 2023 is $50,052M. This figure represents the cash available to all capital providers after accounting for the cash spent on maintaining and expanding the company's operations.
One final note -- When considering the impact of foreign exchange (forex) items, often located at the bottom of the cash flow statement, they can be factored into the FCFF calculation, particularly when they are significant and recurrent. For Microsoft, the forex impact was -$194M in FY 2023. Though not substantial, incorporating this into the FCFF results in a more accurate figure of $49,858M ($50,052M - $194M). This adjusted total more accurately represents the cash available to Microsoft's capital providers, acknowledging the influence of foreign exchange fluctuations during FY 2023.
These deductions from operating income (EBIT) to FCFF can be visualized in a waterfall chart, as shown below:
Consolidating these items into a waterfall chart helps explain Microsoft's activities in FY 2023. The company had an operating income of $88,523M, spent approximately $16,800M on income taxes, adjusted for $7,998M in non-cash expenses, saw little change in its non-cash NWC and forex cash changes, and reinvested $29,777M in CapEx to arrive at an FCFF of $49,858M.
EBITDA to FCFF Formula Example
Now, we can calculate FCFF for Microsoft starting from EBITDA, using the formula below (described earlier):
FCFF = EBITDA × (1 - Tax Rate) + (D&A × Tax Rate) - CapEx - Change in Non-Cash NWC
All of these figures are known except for EBITDA, which is sometimes listed on the company's income statement. This can also be calculated by adding the company's EBIT ($88,523M) to its D&A ($13,861M) to get an EBITDA of $102,384M in FY 2023. Then, we can calculate Microsoft's FCFF as follows:
FCFF [MSFT] = $102,384M × (1 - 0.19) + ($13,861M × 0.19) - $29,777M + $108M --> $54,802M
Thus, the EBITDA to FCFF calculation returns $54,802M. Notably, we didn't just include D&A as the non-cash expense but also non-cash losses (gains) and deferred income taxes (as discussed previously), which technically makes this calculation more accurate.
Net Income to FCFF Formula Example
We can also calculate FCFF for Microsoft starting from net income, using the formula below (described earlier):
FCFF = Net Income + D&A + Interest Expense × (1 - Tax Rate) - CapEx - Change in Non-Cash NWC
We've already identified the necessary inputs to calculate FCFF, except for net income and interest expense, which are found on the company's income statement. Net income is also typically listed at the top of the cash flow statement. For Microsoft, the net income in FY 2023 is $72,361M. The interest expense is categorized under "Other Income, Net" on the income statement. According to the "Notes to the Financial Statements" in the 10-K annual report, Microsoft's interest expense for FY 2023 is -$1,968M. This is outlined in the image below:
With net income and interest expense known, we can calculate Microsoft's FCFF as follows:
FCFF [MSFT] = $72,361M + $7,998M - $1,968M × (1 - 0.19) - $29,777M + $108M --> $49,095M
The net income to FCFF calculation returns $49,095M, closely aligning with the NOPAT to FCFF calculation of $50,052M. This proximity is due to Microsoft's similar NOPAT ($71,723M) and net income ($72,361M) figures, coupled with the company's minimal interest expense for FY 2023.
Cash From Operations (CFO) to FCFF Formula Example
The last FCFF calculation we'll address for Microsoft is from cash from operations (CFO), using the formula below (described earlier):
FCFF = CFO + Interest Expense × (1 - Tax Rate) - CapEx
For this calculation, we have all the required information except for the cash from operations (CFO), which is directly taken from the company's cash flow statement. Microsoft's CFO for FY 2023 is $87,582M.
However, for a more accurate calculation, we'd net out items from CFO that we identified earlier to not be actual non-cash expenses or non-cash NWC items. Specifically, we'd exclude stock-based compensation expense, since this is not considered a non-cash expense, as well as other long-term assets and other long-term liabilities, since these are not considered non-cash NWC items. Thus, the adjusted CFO for FY 2023 would be $80,251M ($87,582M (CFO) - $9,611M (Stock-Based Comp.) + $2,833M (Other LT Assets) - $553M (Other LT Liabilities)).
The FCFF calculation for Microsoft is therefore:
FCFF [MSFT] = $80,251M - $1,968M × (1 - 0.19) - $29,777M --> $48,879M
Here, our result is $48,879M because we're using the CFO figure instead of a profitability figure from the income statement. This simplifies the process since it already includes adjustments for non-cash items and working capital changes. Furthermore, because we adjusted our CFO number, and the cash flow statement typically provides a more accurate/realistic picture of a company's operations than the income statement, this final number may be the most accurate representation of Microsoft's FCFF in FY 2023.
The Bottom Line
Calculating free cash flow to the firm (FCFF), also known as unlevered free cash flow (UFCF), is key for evaluating a company's ability to generate cash from its core operations. FCFF gives investors a clear view of the cash available to debt holders, preferred and common stockholders after paying for operating expenses, including depreciation and amortization (D&A), and investments in capital expenditures (CapEx) and non-cash working capital (WC). It's essential for valuation methods like the discounted cash flow (DCF) model, which forecasts these cash flows to determine a business's value.
The conventional process involves starting with operating income (EBIT), adjusting for taxes to get the net operating profit after taxes (NOPAT), and then accounting for non-cash expenses (like D&A), capital expenditures, and changes in non-cash net working capital (NWC). This method ensures that all cash flows, regardless of their source, are considered, providing a comprehensive overview of the company's financial health. There are also other viable FCFF calculation methods that enable you to get a more nuanced understanding of the cash available to all capital providers. These involve starting from EBITDA, net income, and cash from operations (CFO).
While this article offers a comprehensive overview of FCFF and its calculation, it only briefly mentions "normalization," an important step in forecasting unlevered free cash flows for valuation models like the DCF. Normalization smooths out irregular items and adjusts for non-recurring events in the company's last fiscal year's FCFF. This process ensures the cash flows used in valuations accurately represent the company's ongoing operations, a key aspect of creating reliable projections that help investors make informed decisions.