Cash that is not retained and reinvested in the business is called free cash flow.
It represents cash flow available:
to all the providers of capital of a company
to pay dividends or finance additional capital projects.
Uses of free cash flows
Free cash flows are used frequently in financial management:
as a basis for evaluating potential investment projects
as an indicator of company performance
to calculate the value of a firm and thus a potential share price
Calculating free cash flows for investment appraisal
Free cash flows can be calculated simply as:
Free cash flow = Revenue - Costs - Investments
The free cash flows used to evaluate investment projects are therefore essentially the net relevant cash flows.
Cow plc has earnings before interest and tax of $200,000 for the current year.
Depreciation charges for the year have been $5,000 and working capital has increased by $2,000.
The company needs to invest $20,000 to acquire non-current assets.
Profits are subject to taxation @ 30% p.a.
Calculate free cash flow.
|Less: Corporation tax @ 30%||(60,000)|
|Add back: Depreciation (non-cash amount)||5,000|
|Deduct: Capital expenditure||(20,000)|
|Working capital increases||(2,000)|
|Free cash flow||$123,000|