Free Cash Flow Theory

1305 Words6 Pages
Free cash flow (FCF) is a measure of how much cash a business generates after accounting for capital expenditures such as buildings or equipment. This cash can be used for expansion, dividends, reducing debt, or other purposes.
The formula for free cash flow is:
FCF = Operating Cash Flow - Capital Expenditures.
It can also be calculated as:
EBIT(1-Tax Rate) + Depreciation & Amortization - Change in Net Working Capital - Capital Expenditure

FCFF is a financial performance measure which indicates the net amount of cash generated by the firm after providing for expenses ,taxes and changes in net working capital and investments.
This can be considered as a company's measure of profitability after all expenses and reinvestments.
…show more content…
FCF is a term that has received increasing attention in 1990s. As Jensen states (1986), free cash flow means is the excess of cash generated from its operations over capital expenditure , which are required for all projects of the entity which have positive net present value (NPV). Free cash flow can have useful and important applications for shareholders and managers of entities. The free cash flow theory suggested by Jensen states that more internal cash enables the managers to avoid market controlling. In this situation, they do not need the shareholders agreement and they are free to decide about the investments on their…show more content…
Interpreting free cash flow there are very few companies that have consistently maintained a positive free cash flows. If a firm is increasing its cash flow steadily every year, it usually indicates that it is running its operations efficiently by reducing costs or expanding its market share.
The high free cash also puts the company in a position to pay its debt and give generous dividends to its shareholders. It can also be used to buy other profitable businesses. The companies that are experiencing a steady decline in free cash flow could be going through a period of declining growth and facing liquidity problems. Without free cash, a company may be unable to pay off its debt and may even have to borrow more debt in order to finance its growth requirements. It will not be able to pay dividends, pursue opportunities for expansion through acquisitions or develop new products.
Investors should also be aware that companies can influence their free cash flow by
 lengthening the time they take to pay the bills (thus preserving their
Open Document