How to Normalize Free Cash Flow to the Firm (FCFF)

Updated: March 5, 2024


In this article, I will show you how to normalize free cash flow to the firm (FCFF), also known as unlevered free cash flow (UFCF). FCFF is the cash available to all capital providers in a company, including common stockholders, preferred stockholders, and debt lenders. Normalizing FCFF is necessary to smooth out irregular items and adjust for non-recurring events from the company's last fiscal year, ensuring forecasts are grounded in the company's regular operational performance.

This article will explain how to calculate FCFF, discuss best practices for normalization, and provide a real-world example of calculating FCFF and then normalizing the figure.

How to Calculate Free Cash Flow to the Firm (FCFF)

Free cash flow to the firm (FCFF), also known as unlevered free cash flow (UFCF), 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), investments in capital expenditures (CapEx), and non-cash net working capital (NWC).

There are multiple methods investors can use to calculate FCFF, but the most conventional approach begins with the company's operating income, or EBIT (earnings before interest and taxes), an unlevered profit measure unaffected by interest expenses. This is then adjusted for non-cash expenses like D&A, with CapEx and changes in non-cash NWC subtracted.

The standard EBIT to FCFF formula is shown below:

FCFF = EBIT × (1 - Tax Rate) + D&A - CapEx - Change in Non-Cash NWC


  • FCFF = free cash flow to the firm (aka unlevered free cash flow (UFCF))
  • EBIT = earnings before interest and taxes
  • 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

Here's a detailed breakdown of the FCFF formula components:

  • NOPAT (EBIT × (1 - Tax Rate)): NOPAT (net operating profit after taxes), also known as EBIAT (earnings before interest after taxes), is calculated with the formula "EBIT × (1 - Tax Rate)." This formula modifies EBIT to account for the hypothetical taxes the company would've paid, offering a clearer view of the firm's available cash flow. By doing so, NOPAT highlights operational efficiency, excluding the impact of financing and tax strategies. To calculate the effective tax rate, divide the tax expense by taxable income (i.e., earnings before taxes (EBT)), both found on the income statement.
  • Depreciation and Amortization (D&A): These non-cash expenses are added back to EBIT because they reduce taxable income but do not involve an actual cash outlay. D&A are found on both the income statement and the cash flow statement. While D&A is the most common, other non-cash charges should also be considered for adjustment to ensure the FCFF accurately reflects available cash.
  • Capital Expenditures (CapEx): CapEx refers to the funds used by a company to acquire or upgrade physical assets such as equipment, property, or industrial buildings. This is subtracted because it represents cash outflows necessary for future growth but not available to capital providers in the current period. CapEx details can be found in the investing activities section of the cash flow statement.
  • Change in Non-Cash Net Working Capital (NWC): The change in NWC considered here should specifically target non-cash changes to more accurately reflect operational liquidity movements, which means adjusting for changes in accounts receivable, inventory, and accounts payable, excluding cash and debt. This adjustment is necessary because an increase in NWC signifies a cash outflow, whereas a decrease suggests a cash inflow. The details for calculating this change can be gathered from the cash flow statement.

In summary, the FCFF formula offers a clear perspective on the cash available to all investors after accounting for the costs of maintaining and expanding the business. By focusing on operational profitability (EBIT), adjusting for taxes, adding back non-cash charges, and accounting for investments and operational cash needs (CapEx and NWC), investors can accurately gauge the firm's actual cash-generating capability.

EBIT to FCFF Example

In this section, we'll demonstrate how to calculate free cash flow to the firm (FCFF) for Nvidia (NVDA), a leading technology company specializing in graphics processing units (GPUs) for gaming and professional markets, as well as system on a chip units (SoCs) for the mobile computing and automotive market. We'll base this calculation on its FY 2024 financial statements from its 10-K annual report (ending January 28, 2024).

You can download the file below, which presents Nvidia's income statement, balance sheet, and cash flow statement in a formatted manner, alongside the FCFF calculation models discussed in this article:

The image below demonstrates how FCFF was calculated for Nvidia in FY 2024, with information pulled from the company's income statement and cash flow statement:

Nvidia (Nvda): Ebit To Fcff Calculation
Nvidia (NVDA): EBIT to FCFF Calculation

The EBIT to FCFF calculation begins with operating income (EBIT), which for FY 2024 is $32,972M. The tax rate of 12.0% is calculated by dividing the company's income tax expense ($4,058M) by its earnings before taxes ($33,818M). Then, NOPAT is calculated as follows:

NOPAT [NVDA] = $32,972M × (1 - 0.12) --> $29,016M

Thus, Nvidia's NOPAT in FY 2024 is $29,016M.

Non-Cash Expenses

Next, non-cash expenses have to be added back to NOPAT, given that they're not real cash outflows. For this, besides depreciation and amortization (D&A), deferred income taxes, (gains) losses on investments, acquisition termination cost, and "Other" line items are added back because they represent expenses or losses that do not result in an immediate cash outflow.

Notably, stock-based compensation expense is not added back because it represents a form of compensation that, while non-cash, eventually dilutes shareholders' value and is considered in evaluating the company's expense structure and employee compensation strategy. Thus, the sum of these non-cash expenses in FY 2024 is -$1,497M ($2,052M (Total Non-Cash) - $3,549M (Stock-Based Comp.)).

Capital Expenditures (CapEx)

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Next, we need to subtract the company's capital expenditures. For this, we include the line item "Purchases Related to Property and Equipment and Intangibles," which is usually synonymous with CapEx. We'll also consider "Acquisitions, Net of Cash Acquired" as a CapEx item, even though it's not traditionally considered one. This is because acquisitions result in direct cash outflows impacting FCFF, so ignoring them would be misleading.

On the other hand, investments like purchases, maturities, and sales are excluded from CapEx, as they relate more to financing decisions. Further, "Investments in Non-Affiliated Entities and Other," as described on Nvidia's 10-K annual report, are primarily just marketable equity securities, which would not be classified as a CapEx because they are financial investments rather than expenditures on operational assets or capabilities. Thus, the total of these CapEx items in FY 2024 is -$1,152M (-$1,069M (CapEx) + -$83M (Acquisitions)).

Changes in Non-Cash Net Working Capital (NWC)

Below these non-cash expenses, we have working capital items. We specifically want to focus on non-cash working capital items when calculating FCFF, because they represent operational liquidity that hasn't resulted in actual cash changes during the period.

For this, we consider all of the working capital items except the "Other Long-Term Liabilities" line item, because it pertains to financial obligations not directly related to the company's day-to-day operational activities. The sum of these changes in non-cash NWC is therefore -$4,236M (-$3,722M (Changes in WC) - $514M (Other LT Liabilities)).

Calculate EBIT to FCFF

Now, we can calculate Nvidia's FCFF for FY 2024, as demonstrated below:

FCFF [NVDA] = $29,016M - $1,497M - $1,152M + $4,236M --> $30,603M

Thus, Nvidia's FCFF in FY 2024 is $30,603M, which signifies the amount of cash available to all funding providers (debt holders, preferred and common stockholders) after covering all operating expenses and investments. This figure highlights the company's ability to generate cash from its operations, which is relevant for assessing its financial health, investment potential, and the sustainability of its growth and dividends.

Although this figure can be used for analyzing historical financial data, it is not recommended for valuations and is especially not suitable for forecasting directly. Thus, for forecasting purposes, FCFF should be normalized, as explained in the following section.

How to Normalize Free Cash Flow to the Firm (FCFF)

Normalizing free cash flow to the firm (FCFF) involves excluding non-core operations and one-time items. This adjustment ensures that the cash flow more accurately reflects the company's regular business activities. This process is important for valuations, making it easier to focus on the firm's steady operational performance.

Here's how normalizing FCFF plays a role in the two most popular stock valuation models:

  • Discounted Cash Flow (DCF): In DCF analysis, normalization is needed to ensure that the projected cash flows accurately represent the company’s sustainable operating performance. By adjusting for non-core and non-recurring items, the model reflects a more reliable forecast of the company's value based on its core business operations.
  • Comparable Company Analysis (Comps): With comps, normalization allows for a fair comparison across companies by ensuring that the FCFF-based multiples are derived from operations reflective of each business's ongoing activities. This adjustment is critical for benchmarking the target against its comps without the distortion from one-time events or irregular income/expenses.

Since forecasts are based on the financials of the last fiscal year, the aim is to project future cash flows that accurately reflect the business's core activities. Because normalization ensures that anomalies, non-recurring items, or figures not indicative of ongoing operations are adjusted, this prevents misleading FCFF projections for future periods.

Here's some normalization best practices to follow:

  • Normalize Tax Rate: The effective tax rate applied to EBIT typically varies year-to-year. Therefore, using an average tax rate rather than an anomalous high or low figure from a single fiscal year will normalize the calculated NOPAT figure and avoid misrepresenting the base year for forecasting.
  • Normalize Non-Cash Items: Typical non-cash expenses like depreciation and amortization (D&A) should generally be included in the normalized FCFF due to their consistent and substantial impact on financials. However, items with high volatility, such as non-cash gains or losses and deferred income taxes, should be carefully evaluated. If these items are not consistently reflective of ongoing operations, they may be smoothed out by averaging over a period, or probably in most cases, excluded.
  • Stock-Based Compensation: As previously discussed, stock-based compensation should typically be excluded from FCFF calculations, as it's an in-kind expense rather than a cash expense. It reflects a cost of equity financing that reduces the value available to existing shareholders. Thus, treating it as a non-cash expense would inaccurately inflate FCFF.
  • Normalize CapEx: CapEx figures should reflect the company's regular investment in operations and growth. If CapEx amounts are relatively stable or show a trend, using recent figures may be appropriate. For irregular large expenditures, investors must decide whether to include them based on their recurring nature.
  • Acquisitions: The treatment of acquisitions in normalization depends on their nature. If acquisitions are not recurring and represent a one-time expense, they may be excluded to avoid distorting FCFF. However, if the company has a history of frequent acquisitions, including them may be necessary to accurately reflect the company's operational reinvestment and strategic expenditures.
  • Normalize Changes in Non-Cash NWC: Given the fluctuating nature of working capital, a single year's change might not accurately forecast future movements. Normalizing non-cash NWC involves using a multi-year average or calculating it as a consistent percentage of revenues.

In summary, normalizing FCFF is a nuanced process that refines the cash flow figure to serve as a reliable foundation for future projections. It involves scrutinizing each component for its recurrence and relevance to ongoing operations, ensuring the forecasted FCFF is a true representation of the company's financial health and operational efficiency, thereby enhancing the validity of your valuation models.

Normalizing FCFF Example

This section will describe the process of normalizing our original FCFF calculation of $30,501M for Nvidia in FY 2024. In short, normalizing FCFF is a nuanced process that requires discretion in adjusting figures not expected to recur annually. Having a deeper understanding of a business will always help in normalizing FCFF more accurately.

Normalize Tax Rate

We'll begin by examining the effective tax rate. Initially, we used the 12.0% tax rate for FY 2024, which was calculated by dividing the income tax expense by its taxable income (EBT). However, since tax rates are variable, using a rate that's unusually high or low can skew the base from which forecasting is made. Averaging out the rates is therefore a more prudent approach.

One approach is to simply take the average effective tax rate over the last three fiscal years (2022, 2023, and 2024). The effective tax rates for these years are 1.9%, -4.5%, and 12.0%, respectively. The average of these rates is 3.1%, which will replace the 12.0% rate in our normalized FCFF calculation. Although this rate is relatively low, it may be reasonable given that the company has received many federal tax benefits in the past. However, if you wanted to be more conservative, you could also just continue to use the 12.0%.

Normalize Non-Cash Items

Next, we'll address non-cash expense items. Previously, we accounted for depreciation and amortization (D&A), deferred income taxes, (gains) losses on investments, acquisition termination costs, and "Other," as non-cash expenses, while also appropriately excluding stock-based compensation.

We'll continue to include D&A, which for Nvidia in FY 2024 is $1,508M, as it's a standard and recurring non-cash expense. However, we'll exclude all other non-cash expenses, due to their small values, lack of predictability, and/or non-recurring nature.

It may be reasonable to average out the deferred income taxes and include them, considering their relatively larger impact on the total non-cash expense number. However, we'll just exclude it altogether since it's difficult to consider when forecasting FCFF.

Normalize CapEx

For CapEx, we'll retain the number from FY 2024, -$1,069M. However, for the acquisitions line item, if it's not a regular occurrence, it should be omitted from the normalized FCFF. Given that Nvidia had acquisition cash outflows over the last 3 years, and under the assumption that Nvidia continues to acquire companies, it's likely that this cash outflow will continue to recur in the future.

Therefore, we'll just take an average of the acquisitions cash outflows over the past three fiscal years (2022, 2023, and 2024), which are -$263M, -$49M, and -$83M respectively, leading to a normalized acquisition number of -$132M. Adding this to the CapEx number gives a normalized total CapEx figure of -$1,201M.

Normalize Changes in Non-Cash NWC

The next consideration is changes in non-cash net working capital (NWC). Since working capital is relatively volatile, simply taking the last year's change might not accurately predict future changes. It's advisable to smooth this number, for instance, by calculating non-cash NWC as a percentage of revenue over an extended period or averaging it over a set period.

In this instance, we'll calculate Microsoft's non-cash NWC for the past three fiscal years (2022, 2023, and 2024), which are -$3,555M, -$2,459M, and -$4,236M respectively. Averaging these provides a total non-cash NWC figure of -$3,417M, which also avoids having to adjust every non-cash NWC line item in the cash flow statement.

Calculate Normalized FCFF

Finally, the normalized FCFF for Nvidia in FY 2024, starting from operating income (EBIT), is calculated as follows:

Normalized FCFF [NVDA] = $32,972M × (1 - 0.031) + $1,508M - $1,201M + $3,417 --> $35,660M

This normalized FCFF calculation is also shown in the model below:

Nvidia (Nvda): Normalized Fcff Calculation (Fy 2024)
Nvidia (NVDA): Normalized FCFF Calculation (FY 2024)

Thus, our normalized FCFF calculation for Nvidia in FY 2024 is $35,660M. This, as opposed to our original FCFF calculation of $30,603M, provides a baseline cash flow from which to project future unlevered free cash flows, ensuring a more accurate forecast by not building upon a figure that could include one-time, unpredictable, and/or abnormal figures.

The Bottom Line

Free cash flow to the firm (FCFF), also known as unlevered free cash flow (UFCF), is the cash flow available to all funding providers (debt holders, preferred stockholders, and common stockholders) after covering operating expenses, investments in capital expenditures (CapEx), and changes in non-cash net working capital (NWC). This calculation provides a clear view of the cash generated by a company that is available for distribution to all capital providers, highlighting the firm's ability to generate cash from its operations.

Normalization of FCFF is an important step that involves adjusting the raw FCFF to ensure it accurately represents the company's regular and ongoing business activities. This process includes removing the effects of non-core operations and one-time items from the FCFF calculation.

The need for normalization arises because companies often have irregular income or expenses that can significantly affect their financials in any given year, such as extraordinary gains or losses, acquisitions, or changes in tax rates. By normalizing these figures, valuations can concentrate on the company's core, sustainable operational performance, making it easier to project future cash flows and compare the company's financial health across different periods or against other firms.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance, investment, or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.

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