Oct 3, 2021 FINANCE 101

The ­final cash measure is free cash-flows, one of the most important measures of economic performance in ­finance. You’ll see this number again and again when you look at how companies are valued or when companies discuss how they’re doing. The equation for calculating free cash-flows provides a measure of the amount of cash-flows truly unencumbered by the operations of a business. It’s the purest measure of cash and forms the basis of valuation. It removes the distorting effects of non-cash charges such as depreciation and amortization (like EBITDA), accounts for changes in working capital (like operating cash ‑ow), and fi­nally, acknowledges that capital expenditures are required for growth and have been avoided so far. In short, free cash ‑ow isolates the cash that is truly free to be distributed or used however the company sees ­fit.

Free Cash Flow Equation:

Free Cash Flow (FCF) = EBIT – taxes + depreciation and amortization

                                     +/- changes in working capital + Capital expenditures

You can visualize it by thinking about a simplifi­ed balance sheet. The net assets side of the balance sheet is divided between working capital (e.g., inventories and accounts receivables less accounts payable) and fixed assets (e.g., property, plant, and equipment), and the financing side of the balance sheet is divided between debt and equity.

This modifi­ed balance sheet now distinguishes between the operations (the left-hand side) and the capital providers’ (the right-hand side). The flows that operations generate that end up with the capital providers are the free cash-flows, which are calculated as follows.

By thanhnambui

I am a bank employee specializing in trade finance- a field that is not directly linked to my university major in Financial Investment. However, with a passion for economics and finance, I determined to pursue a higher education degree and successfully achieved a Master in Economics of Banking and Finance from CFVG in 2019. During that study time, I encountered many difficulties in consolidating background knowledge studied at university, which made me realize the necessity of building foundation for effective learning outcomes. Therefore, my friend and I decided to create Econfin-Invest to record basic knowledge of economics, banking, finance, and investment fields. The articles I write are carefully selected and collected from a wide range of different reliable sources such as textbooks, economic and financial reports and relevant journals. Most importantly, these articles are not A to Z lectures of subjects related to the aforementioned fields, yet simply articles I consider to be accessible to all interested readers as well as being essential to apply in everyday practices. Thank you for reading and supporting!

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