What is Free Cash Flow (FCF)?

Free cash flow (FCF) is an important indicator that reflects the ability to generate cash after paying the necessary expenses for business operations. Understanding what free cash flow is will help businesses be flexible in paying debt, investing, and paying dividends. 

Let's learn about the role and effective management of free cash flow in a business through this article by Bizzi.

1. What is free cash flow?

Free cash flow (FCF) is the amount of cash remaining after a business has paid all the costs necessary to maintain its operations, including operating expenses (OpEx) and capital expenditures (CapEx). FCF not only reflects profitability but also assesses the ability to generate sustainable profits and maintain stable financial operations over the long term.

2. Understand the characteristics of free cash flow

  • Can be negative or positive

If FCF is positive, the business has enough money to expand, pay dividends, or reduce debt. Conversely, the business is spending more money than it generates, possibly due to heavy investment in assets or financial difficulties.

  • Flexibility

Businesses can use FCF for a variety of purposes, such as paying down debt, investing in growth, paying dividends, or buying back shares.

  • Not displayed directly

FCF is not a measure that appears directly in financial statements under GAAP or IFRS, but can be calculated from figures in the cash flow statement and income statement.

  • Not affected by accounting factors

Unlike net income and EBITDA, FCF is not affected by accounting factors such as depreciation, provisions or other accounting adjustments.

  • Subject to change

If a company changes its investment strategy or experiences fluctuations in its working capital management, FCF may change. For example, during an expansion phase, FCF may decrease as the company invests heavily in assets (increased CapEx). Conversely, during a stabilization phase, FCF may increase as capital expenditures decrease.

  • Business valuation

Investors use FCF to assess a company's intrinsic value, as it shows the company's ability to generate cash, unaffected by accounting principles. In other words, FCF reflects the company's actual ability to generate cash.

3. The role and significance of free cash flow

For business

  • Financial “health” assessment 

Free cash flow – FCF helps businesses determine their ability to maintain operations without borrowing or raising external capital, or in other words, their ability to generate cash after paying for the investments needed to maintain and grow. If FCF is positive and stable, it shows that the business has the ability to generate sustainable profits. On the contrary, persistent negative FCF can be a sign of poor financial management or ineffective investment.

  • Managing dividends and debt 

FCF allows a company to pay dividends or reduce debt without affecting its core business. Businesses with good FCF are able to repay debt on time, reducing financial pressure. When it needs to expand, businesses can borrow capital at better interest rates, because banks and credit institutions often evaluate FCF to consider debt repayment ability.

  • Reinvest and scale 

Used to reinvest in development projects, acquire other companies or expand without borrowing too much. High FCF allows businesses to upgrade infrastructure, recruit good staff, invest in research & development (R&D) to maintain competitive advantage.

  • Make strategic financial decisions 

Help companies make strategic financial decisions such as maintaining appropriate debt levels, optimizing equity, or implementing sustainable growth strategies.

  • Optimize and minimize financial risks 

Helps companies become self-sufficient and reduce financial risks from loans or other external factors. FCF helps businesses plan long-term finances, control cash inflows and outflows, and manage capital expenditures (CapEx) effectively.

If FCF is negative for a long period of time, businesses need to consider cutting unnecessary spending or optimizing cash flow from operations.

  • Impact on dividend & stock buyback strategy

If a company has excess FCF, it can pay higher dividends or buy back shares, increasing shareholder value. A company with a stable dividend policy based on FCF is often attractive to long-term investors.

For investors

  • Business valuation

FCF is an important indicator in the Discounted Cash Flow (DCF) model to determine enterprise value. Enterprise value (EV) is determined based on the ability to generate FCF in the future.

  • Reflecting performance

Free cash flow assesses the potential and financial situation, showing the ability to generate cash flow from production and business activities. Investors can take advantage of buying stocks at low prices when FCF increases steadily, thereby opening up investment opportunities.

  • Assessing debt repayment capacity & financial risk

Businesses with strong free cash flow are less dependent on debt, thereby reducing financial risk. If negative FCF persists, investors need to consider the cause: Is it expansion investment or ineffective business operations?

  • Long-term investment strategy orientation

Stocks of companies with high and sustainable FCF are often of interest to long-term investment funds. Conversely, if a company has negative FCF but is investing in potential projects, investors may consider investing for the long term.

4. Formula for calculating free cash flow

The discounted free cash flow (DCF) method helps determine the intrinsic value of a business based on its future cash generation potential. Investors and businesses can use DCF to make informed investment decisions.

  • Common formula: FCF = OCF (Net Cash Flow) – CAPEX (Capital Expenditures).
    • OCF = EBIT – Depreciation – Taxes or OCF = Total Revenue – Total Operating Expenses. EBIT = Earnings Before Interest and Taxes.
    • CAPEX (1 year) = Current PPE – Previous year PPE + Asset depreciation.

In there:

  • OCF (Operating Cash Flow): Net cash flow from operating activities (taken from cash flow statement).
  • CapEx (Capital Expenditures): Investment costs in fixed assets such as factories, machinery, and equipment.

For example, if a company has cash flow from operations of $10 million, and capital expenditures (CapEx) of $3 million, then FCF = $7 million.

  • Alternative formula: FCF = Net income + Depreciation – Net working capital – Capital expenditures.

In there:

  • Net income: The amount of money a business receives after all expenses have been deducted.
  • Depreciation: Amounts exempted or deducted as prescribed.
  • Net working capital: The increase or decrease in capital invested in a business.
  • Cost of capital: Costs calculated over a period of more than 1 year of the business.

5. Steps to discount free cash flow

  • Step 1: Free cash flow forecast: Forecast over a 5-year period for a stable growth business.
  • Step 2: Calculate the weighted average cost of capital (WACC):

Formula: WACC = Rd × Fd × (1 – t) + Re × Fe.

In there:

  • Rd: Cost of debt of the enterprise.
  • Fd: Ratio of long-term debt to total long-term capital.
  • t: Corporate income tax rate.
  • Re: Cost of equity.
  • Fe: Ratio of equity to total long-term capital.
  • Step 3: Forecast terminal value (TV).
  • Step 4: Calculate enterprise value.

6. Notes on free cash flow

  • Impact on working capital and capital expenditure: Changes in working capital and capital expenditures can have a strong impact on free cash flow (FCF).
  • No forecast of profitability: FCF cannot predict future earnings growth or maintenance.
  • Complex calculations: Calculating FCF requires careful analysis of factors such as pre-tax profit, changes in working capital, capital expenditures and taxes.
  • Difficult to compare across industries: FCF can be difficult to compare across businesses in different industries.
  • High free cash flow is not always good and vice versa: High FCF is sometimes a sign that a company is not investing enough in its business. And if FCF is negative, it may be that the company is investing heavily to expand its market share.

7. Steps to effectively manage finances with Bizzi

Use cash flow management tools modern helps businesses solve cost and budget problems effectively. Bizzi Expense is one of the leading business financial management tools today, providing an automated solution for the business's expense reporting process, easy to track and Cash flow management smartly without spending much time and effort.

Outstanding features of Bizzi Expense:

  • Track and Real-time cost management: The system updates transactions and expenses as they occur, helping managers stay on top of the company's financial situation in real time.
  • Cost and budget reporting dashboard: Provides intuitive dashboards with detailed reports and easy-to-understand charts, helping users easily track costs and budgets at any given time. Automatic reports help managers gain an overview and insight into the efficiency of their business's resource use without the need for complicated operations.
  • Set spending policy: Allows businesses to easily set up and customize spending policies for each department, project, or expense type, and tightly control free cash flow (FCF). Spending limits are clearly defined, and the system will automatically alert when there is overspending or non-compliance with policies.
  • Flexible expense approval process: Approval flows are set up based on level and expense type, users can request configuration design to meet internal needs, ensuring approval processes are done quickly, anytime, anywhere.
  • Budgeting for departments and projects: Bizzi Expense helps businesses allocate and manage detailed budgets for each department, project, or specific spending category.
  • ERP integration: Bizzi Expense integrates seamlessly with major ERP systems, helping to synchronize expense and budget data from multiple sources into one platform.

8. Benefits of using Bizzi Expense – A powerful free cash flow management tool for businesses

Automate cost management processes, optimize cash flow:

  • Minimize manual operations, automate invoice and document processing, helping businesses reduce data entry time by 80%.
  • Optimize operating costs, eliminate traditional paperwork, reduce errors and save accounting staff.
  • Standardize approval and spending processes flexibly, helping to control budget effectively.

Improve free cash flow (FCF) through tight expense control:

  • Real-time expense tracking: Automatic reports help businesses control costs instantly, thereby optimizing free cash flow (FCF) positive.
  • Reduce budget loss: Verify transactions and control invalid charges instantly.

Flexible integration with accounting and ERP systems

  • Easily connect with accounting software such as MISA, SAP, Oracle, helping to automatically synchronize cost data.
  • E-invoice integration: Supports electronic invoice processing, reduces errors and increases transparency.
  • Multi-platform management: Use on mobile & web, convenient for businesses with many branches.

Support smart financial decision making

  • Detailed, intuitive reports: Provide financial analysis by department and project, helping managers easily adjust budgets.
  • Optimizing FCF for reinvestment: By effectively controlling expenses, businesses can increase FCF to expand their business without borrowing.
  • Improve supplier relationships: Pay on time, take advantage of better deals and discounts.

Understanding what free cash flow is and the role of free cash flow in a business is an important key for businesses to expand their business, optimize their finances and reduce debt risks. Bizzi Expense is a powerful support tool that helps businesses manage and optimize free cash flow (FCF), ensuring strong finances for sustainable development.

Sign up for a free trial now at: https://bizzi.vn/dang-ky-dung-thu/

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