FCFF vs FCFE: Understanding the Basics

In financial analysis, Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE) are two crucial metrics used to evaluate a company's financial health and cash flow dynamics. These metrics help investors and analysts assess a company's ability to generate cash and its potential for growth. In this blog, we will delve into the definitions, formulas, and differences between FCFF and FCFE, along with easy-to-understand examples.

1. Free Cash Flow to Firm (FCFF)

FCFF, also known as unlevered free cash flow, represents the cash flow available to all capital providers of a company, including both debt and equity holders. It is a measure of a company's ability to generate cash after meeting its operating expenses and capital expenditures.

Formula for FCFF:

FCFF = Cash Flow from Operations + Tax Adjusted Interest Expense − Capital Expenditures

Alternatively,

it can be calculated using:
FCFF = EBIT (1−Tax Rate) + Depreciation − Capital Expenditures − Change in Working Capital

Example:

Suppose a company has the following financials:

• Cash Flow from Operations: Rs 100,000
• Tax Adjusted Interest Expense: Rs 20,000 (assuming a tax rate of 25%)
• Capital Expenditures: Rs 50,000

FCFF = 100,000 + 20,000 − 50,000 = Rs 70,000

2. Free Cash Flow to Equity (FCFE)

FCFE, or levered free cash flow, represents the cash flow available specifically to equity shareholders after meeting all expenses, debt obligations, and reinvestment needs. It indicates the amount of cash that can be distributed to shareholders without jeopardizing the company's operations.

Formula for FCFE:

FCFE = FCFF + Net Borrowing − Interest Expense (1−Tax Rate)

Alternatively, it can be calculated using:
FCFE = Cash Flow from Operations − Capital Expenditures + Net Debt Issued

Example:

Continuing from the previous example, let's assume:

• FCFF: Rs 70,000
• Net Borrowing: Rs 10,000
• Interest Expense before tax: Rs 80,000 (with a tax rate of 25%)

Interest Expense after tax=80,000×(1−0.25)=Rs 60,000

FCFE = 70,000 + 10,000 − 60,000 = Rs 20,000

Choosing Between FCFF and FCFE

• FCFF is preferred when evaluating a company's overall financial health and ability to service debt and equity. It is also useful for comparing companies with different capital structures.
• FCFE is ideal for equity valuation, especially when the dividend policy is unstable or when assessing the cash flow available to shareholders.

In conclusion, both FCFF and FCFE are essential tools in financial analysis, each serving different purposes depending on the perspective of the investor or analyst. Understanding these metrics can help in making informed investment decisions and evaluating a company's financial stability and growth potential.