Free cash flow to the firm (FCFF) and free cash flow to equity (FCFE) are two of the most important metrics used in financial modeling. Both metrics measure the amount of cash that is available to a company's shareholders and creditors, but there is a key difference between the two.
FCFF measures the cash flow that is available to all capital providers, including debt holders and equity holders.
FCFE, on the other hand, measures the cash flow that is available to equity holders only.
How to Calculate FCFF and FCFE
FCFF is calculated by subtracting capital expenditures (capex) from free cash flow (FCF). FCF is calculated by subtracting net income from operating activities from net investments in working capital.
FCFF = FCF - capex
FCFE is calculated by subtracting interest expense and net income tax expense from FCFF, and then adding back in net debt issuance.
FCFE = FCFF - interest expense - net income tax expense + net debt issuance
Why are FCFF and FCFE important?
FCFF and FCFE are important metrics for investors because they measure a company's ability to generate cash flow that can be used to pay dividends, invest in new growth opportunities, or repay debt.
FCFF is particularly important for creditors, as it is a measure of how much cash a company has available to service its debt obligations. FCFE is important for equity investors, as it is a measure of how much cash a company has available to return to its shareholders in the form of dividends or share buybacks.
How to use FCFF and FCFE
FCFF and FCFE can be used in a number of ways, including:
- Company valuation: FCFF and FCFE can be used to value companies using discounted cash flow (DCF) analysis. DCF analysis is a valuation method that estimates the value of a company based on the present value of its future cash flows.
- Credit analysis: FCFF can be used to assess a company's creditworthiness and ability to repay its debt obligations.
- Dividend sustainability: FCFE can be used to assess a company's ability to sustain its dividend payments.
- Investment analysis: FCFF and FCFE can be used to compare the investment potential of different companies.
When to Use FCFF and FCFE
FCFF is typically used to value companies, while FCFE is used to value equity. FCFF is also used to evaluate a company's ability to service its debt.
Example:
Let's say that a company has the following financial statements:
| Income Statement | Amount |
| Revenue | $100 million |
| Cost of goods sold | $60 million |
| Operating expenses | $30 million |
| Net income | $10 million |
| Balance Sheet | Amount |
| Cash | $20 million |
| Accounts receivable | $10 million |
| Inventory | $5 million |
| Total assets | $35 million |
| Accounts payable | $5 million |
| Accrued expenses | $2 million |
| Long-term debt | $10 million |
| Total equity | $18 million |
To calculate FCFF, we would first calculate FCF:
FCF = Net income - Net investments in working capital
Net investments in working capital is calculated by subtracting the change in accounts receivable and inventory from the change in accounts payable and accrued expenses. In this example, net investments in working capital is equal to $3 million.
Therefore, FCF is equal to:
FCF = $10 million - $3 million = $7 million
To calculate FCFF, we would then subtract capex from FCF:
FCFF = FCF - capex
In this example, capex is equal to $2 million.
Therefore, FCFF is equal to:
FCFF = $7 million - $2 million = $5 million
Conclusion
FCFF and FCFE are two important metrics that can be used to value companies and evaluate their financial performance. FCFF is typically used to value companies, while FCFE is used to value equity. FCFF is also used to evaluate a company's ability to service its debt.
