What is Free Cash Flow? [REVISED] Meaning, Calculations, Variations, and IFRS Differences

You’ll learn all about Free Cash Flow in this tutorial, including what it means, how to calculate it, how it’s different under IFRS, and how some key variations, such as Unlevered Free Cash Flow and Levered Free Cash Flow, differ.

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Table of Contents:

0:00 Introduction

1:24 Part 1: Calculations and Basic Meaning

6:49 Part 2: Different Variations of Free Cash Flow

9:26 Part 3: Complications and Differences Under IFRS

13:38 Part 4: Company Analysis: Free Cash Flow in Real Life

18:14 Recap and Summary

Lesson Outline:

The basic definition of Free Cash Flow, or FCF, is Cash Flow from Operations minus Capital Expenditures (CapEx).

Free Cash Flow tells you how much cash a company is generating after paying for the cash cost of its funding (e.g., interest on Debt), paying to maintain its capital assets, and paying for other  items required to run the business, such as Inventory.

You exclude other CFS line items, such as Dividends, because they are non-recurring or “not required” to keep the business running.

And it's pointless to factor in Equity and Debt issuances and repayments because FCF is supposed to tell us whether or not the company needs these outside capital issuances in the first place.

Generally, it’s best for FCF to be positive and growing rather than negative and declining or stagnant.

If FCF is negative for a prolonged period, the company must rely on outside financing to stay alive, which is a dangerous state to be in.

It’s best if FCF is growing because its sales are growing, and it is becoming more efficient (higher margins).

It’s less positive if the company’s FCF is growing because it keeps cutting costs or reducing its CapEx spending.

And it’s a real warning sign if FCF is growing, but the company’s sales are falling and it’s “playing games” with Working Capital, Depreciation, CapEx, or non-core business activities.

Target is not a “growth company” here, but its FCF is positive and growing, in-line with sales growth, and its margins stay in a similar range each year. Its declining CapEx relative to CFO is a bit concerning since that explains some of the growth here.

FCF Variations

Unlevered FCF (UFCF) = Free Cash Flow to Firm (FCFF): You modify FCF to exclude or add back Net Interest Expense and Preferred Dividends and Other Income/Expenses.

Unlevered FCF (UFCF): Represents the core business’s cash flow on a capital structure-neutral basis – widely used in the DCF.

Levered Free Cash Flow (LFCF) = Free Cash Flow to Equity (FCFE): It’s similar to normal “FCF,” but you also factor in Debt Issuances/Repayments here (unclear whether it should be all, just mandatory repayments, etc.).

We do not like to use the LFCF metric because of the disagreements over the definition and the fact that UFCF is better in valuations and FCF is better for quick analysis.

IFRS Differences

Issue #1: IFRS Cash Flow Statements do not necessarily start with Net Income, so “Cash Flow from Operations” might be wrong!

If it doesn’t deduct the Net Interest Expense, Preferred Dividends, the full Lease Expense, etc., then you will have to adjust it.

Issue #2: There is “Lease Depreciation” on the financial statements under IFRS, so when you add back D&A to FCF, UFCF, etc., you cannot add back this portion of the D&A!

We do this for Fortum, a Finnish company, because a small portion of the D&A on its CFS corresponds to the Depreciation element of the Operating Lease Expense.

Analysis of Best Buy and Zendesk

Best Buy has positive FCF each year, and it grows by 10 – 15% in Years 2 and 3.

But it’s also far above the revenue growth rate of 1-2%, and it’s partially because of lower CapEx (and rising margins?).

With Zendesk, FCF is also positive and growing, and at different rates than revenue.

But a major driver seems to be the Change in WC, as well as the company’s high Stock-Based Compensation add-back.

Neither company is “doing poorly,” but Zendesk is far less sustainable than it appears at first glance because its SBC is almost bigger than its Net Income (which is quite negative).

And Best Buy is clearly a sustainable business, but its FCF growth might be a bit overstated because of the issue with CapEx and changing margins.