What It Is:
The firm's investors include both bondholders and stockholders.
How It Works/Example:
A company must continually invest in itself in order to keep operating. Short-term assets like inventoryand receivables (called working capital) get used up and need to be replenished. Long-term assets like buildings, plants and equipment need to be expanded, repaired and replaced as they get older or as the business grows.
Once the company has paid its bills and reinvested in itself, hopefully it has some money left over. This is the free cash flow to the firm (FCFF), called such because it's available (free) to pay out to the firm's investors.
To calculate free Cash flow to the firm, you can use one of four different formulas. The main differences among them pertain to which income measure you start from and what you then add and subtract to the income measure to end up with FCFF:
FCFF = NI + NCC + Int * ( 1 – T ) – Inv LT – Inv WC
FCFF = CFO + Int * ( 1 – T ) – Inv LT
FCFF = [EBIT * ( 1 – T )] + Dep – Inv LT – Inv WC
FCFF = [EBITDA * ( 1 – T )] + ( Dep * T ) – Inv LT – Inv WC
NI = net income
NCC = non-cash charges
Int = net interest
T = tax rate
Inv LT = investment in long-term assets
Inv WC = investment in working capital
CFO = Cash flow from operations
Dep = depreciation
All of these inputs can be found in the company's financial statements.
Why It Matters:
Technical analysts aside, most investors buy a stock because you they believe the company will pay them back in the future via dividend payments or stock repurchases. A company can only pay you back if it generates more cash than it spends. Hence the importance of calculating free cash flows.