Free Cash Flow to Firm: What It Is and Who It Belongs To

Free cash flow to the firm is the cash a business produces after tax and after reinvestment, and before any lender or shareholder is paid. For Sankalp Industrial Systems Limited, invented, it runs from Rs 98,00,00,000 in Year 1 to Rs 1,70,00,00,000 in Year 5. The cash belongs to everybody who funded the business, lenders and shareholders together, so it is discounted at one blended rate rather than at a cost of equity.

Start on a lane in a small town with a man who runs one goods tempo. He drives it himself, he took a loan for two thirds of what it cost, and he keeps his accounts in a notebook that also holds his son's cricket scores. Last year the tempo brought in Rs 9,60,000 of freight. Diesel, tolls, tyres, the mechanic and the road tax took Rs 5,40,000. He paid Rs 60,000 of tax on what was left. And because he had picked up a regular run to a mandi forty kilometres out, he spent Rs 1,20,000 on a second-hand trailer he now tows behind the tempo three days a week.

Ask him what he made and the answer is Rs 3,60,000, the freight less the running costs less the tax. Ask him what he has, and the trailer took Rs 1,20,000 of it, so the answer is a different number: Rs 2,40,000. And ask what happened to that Rs 2,40,000 and the answer is that the finance company took Rs 96,000 of instalment and the rest went home with him.

Everything that follows lives in the order of that last sentence. There was a pool of Rs 2,40,000 that existed before the finance company was paid and before he took anything home. The tempo produced that pool. The loan did not produce it and his own savings did not produce it, and the pool did not care which of the two had bought the vehicle. The loan and the savings only decide how the pool gets divided afterwards.

The pool has a name. In a company it is called free cash flow to the firmCash after tax and reinvestment, before any lender or shareholder is paid., and everything difficult about it becomes easy the moment the tempo is held in mind. Free cash flow to the firm is the cash the operating business hands over after it has paid its tax and bought whatever it needed to buy, and before a single rupee has gone to anybody with a claim on it.

What is free cash flow to the firm, in one sentence?

The sentence is this. Free cash flow to the firm is the cash a business produces after tax and after reinvestmentProfit put back into the business rather than paid out., and before any lender or shareholder is paid. Three phrases in that sentence do all the work, and each of them rules out a question people put to the measure.

After tax means the government has already been dealt with, and the government is not a claimant on the pool in the sense the other two are. Nobody argues about whether tax comes out first. But there is a specific twist here that catches almost everybody, and it is taken up properly below: the tax subtracted inside this measure is the tax the company would pay if it carried no borrowed money at all. Not the tax it actually paid.

After reinvestment means the business has already bought its machines and funded its extra stock and receivables for the year. Reinvestment is the phrase that makes the measure useful, and also the phrase that makes it look bad in a good year. Cash spent on a new machine is gone. The machine exists, but the cash is gone, and it is not available to anybody.

Before any lender or shareholder is paid is the phrase that names whose money it is. Ownership decides everything else, including the rate the measure has to be discounted at, and ownership is the reason the measure carries the words to the firm in its title rather than to shareholders.

Notice the three things the sentence leaves out. The sentence says nothing about a bank account, nothing about a cash flow statement, and nothing about what the company chose to do with the money. Free cash flow to the firm is a measure of what the operating business generated, not a record of what happened to it. That distinction is doing quiet work all the way through, and when it is forgotten the errors that follow are large and confident.

How is it built, and is there more than one route to the same number?

There are two routes and they are the same arithmetic written twice. Both are worth knowing. The long way shows which line items are involved, and the short way shows the measure's real claim.

The long way starts from net operating profit after tax, NOPATNet operating profit after tax: EBIT less tax, with no interest deducted., adds back depreciation, subtracts capital expenditure and subtracts the movement in net working capital. Take Sankalp Industrial Systems Limited, invented, in Year 1 of its five year forecast. Operating profit is Rs 2,64,00,00,000. Tax at the company's own assumed effective rate of 25.0 per cent is Rs 66,00,00,000, and that rate is an assumption of this forecast rather than a statement about any tax law anywhere. So NOPAT is Rs 1,98,00,00,000.

Now the four lines. Depreciation was subtracted to reach operating profit, but no cash left the building when it was charged, so add Rs 52,80,00,000 back. Capital expenditure of Rs 1,34,80,00,000 genuinely did leave the building, so subtract it. Growing revenue by Rs 1,20,00,00,000 means carrying more stock and waiting on more invoices, and that too is cash sitting somewhere other than in the pool, so subtract the movement in net working capital of Rs 18,00,00,000.

Rs 1,98,00,00,000 plus Rs 52,80,00,000 less Rs 1,34,80,00,000 less Rs 18,00,00,000 is Rs 98,00,00,000. Rs 98,00,00,000 is Year 1 free cash flow to the firm, and the valuation that follows starts from that figure.

Route two, and why it is the one worth remembering

Look again at the three lines that follow NOPAT. Depreciation is added, capital expenditure is subtracted, and the working capital movement is subtracted. Adding one thing and subtracting another is the same as subtracting the difference between them. So group them: capital expenditure less depreciation plus the movement in working capital. The grouping has a name of its own. The name is net new invested capitalCapital expenditure less depreciation plus the movement in net working capital., and for Sankalp Industrial Systems Limited in Year 1 the grouping is Rs 1,34,80,00,000 less Rs 52,80,00,000 plus Rs 18,00,00,000, giving Rs 1,00,00,00,000.

So free cash flow to the firm is NOPAT less net new invested capital, and here that means NOPAT less Rs 1,00,00,00,000. Rs 1,98,00,00,000 less Rs 1,00,00,00,000 is Rs 98,00,00,000, which is where the long way landed too. There is no third route and there is no fourth line; a model that adds one has invented it.

Now do the same thing to the other four forecast years and something striking happens. The reinvestment figure does not move. The figure is Rs 1,00,00,00,000 in Year 2, and in Year 3, and in Year 4, and in Year 5. So the whole five year series is just the NOPAT series with the same rupee amount taken off each year.

Read the last two rows together. NOPAT rises by exactly Rs 18,00,00,000 a year. The reinvestment does not rise at all. So free cash flow to the firm also rises by exactly Rs 18,00,00,000 a year, from Rs 98,00,00,000 to Rs 1,70,00,00,000, a rise of 73.47 per cent across the five years. The price of the growth was already fixed, so every rupee of the increase in profit reaches the pool.

Why does the same Rs 1,00,00,00,000 come out in every one of the five years?

Because two of the three ingredients are constant by construction and the third is constant by assumption. The check is worth twenty seconds. A reader who has not made it will suspect the forecast was assembled and hoped over rather than built to agree.

The movement in net working capital is Rs 18,00,00,000 in every year, and that is easy to see: revenue rises by exactly Rs 1,20,00,00,000 a year, net working capital is held at 15.0 per cent of revenue, and 15.0 per cent of Rs 1,20,00,00,000 is Rs 18,00,00,000. Same increment, same ratio, same answer, five times.

The other two are less obvious. Capital expenditure rises every year, from Rs 1,34,80,00,000 to Rs 1,54,00,00,000. Depreciation also rises every year, from Rs 52,80,00,000 to Rs 72,00,00,000. Both are moving. But capital expenditure less depreciation is exactly Rs 82,00,00,000 in every one of the five years. Capital expenditure was set at a falling share of a rising revenue, 10.21 per cent in Year 1 down to 8.56 per cent in Year 5, and the falling share is precisely what holds the gap over depreciation still.

Rs 82,00,00,000 plus Rs 18,00,00,000 is Rs 1,00,00,00,000. The sum is the whole of it, and the arithmetic is the shortest proof available that these five forecast lines were built to agree with one another rather than typed in one at a time and left to collide.

Who does this cash actually belong to?

To two groups, together, and to nobody else. Ask who has a claim on the cash a business generates and there are exactly two answers: the people who lent it money and the people who hold its shares. For Sankalp Industrial Systems Limited that is the providers of Rs 6,00,00,00,000 of gross debt on one side and the holders of 20,00,00,000 shares on the other.

Free cash flow to the firm is the pool before either group has taken anything out of it. Not the lenders' slice, not the shareholders' slice, and not the two added together after the fact. The pool sits above both groups, and that position decides everything else about the measure.

Go back to the tempo. The Rs 2,40,000 the vehicle produced did not belong to the finance company, and it did not belong to the driver either. The Rs 2,40,000 belonged to both, in an order set by their agreement: the finance company has first claim up to its instalment, and the driver has everything after that. But the tempo produced the same Rs 2,40,000 whichever of them had put up the money. The vehicle does not know how it was paid for.

The one question that settles every hard case

Line items not listed here will turn up. A payment to a supplier, a fine, a dividend, a lease instalment, a repayment of principal. Rather than a rule for each, one question settles all of them: is this a cost of producing the cash, or is it a payment to somebody who has a claim on the cash?

If it is a cost of producing the cash, it stays inside the measure and is deducted. Raw material, wages, power, the tax on operating profit, the machines, the extra stock. All of those had to happen for the pool to exist at all.

If it is a payment to a claimantAnybody with a right to the cash a business produces, meaning lenders and shareholders here., it sits below the measure and is not deducted. Interest is a payment to a lender. A dividend is a payment to a shareholder. A share buyback is a payment to a shareholder. Repaying borrowed money is a payment to a lender. All four are a distributionA payment out of the pool to a claimant, rather than a cost of producing it. out of the pool rather than a cost of filling it.

The question is not a memory aid but the definition doing its own work. And it is why a modeller who can say whose money a line item is can settle a case they have never seen before without looking anything up.

Why is it struck before interest, when interest is obviously paid?

Because interest is a payment to one of the two claimants, and the measure is defined as the pool before either claimant is paid. Sankalp Industrial Systems Limited will pay Rs 48,00,00,000 of interest in Year 1 on Rs 6,00,00,00,000 of opening gross debt at a blended 8.00 per cent, the company's own contracted rate and an assumption of this forecast. The payment is real. It happens. The payment just happens out of the Rs 98,00,00,000 rather than before it.

There is a second consequence of that choice which readers miss and which matters more than it looks. Real tax is computed after interest has reduced taxable profit. So if no interest is deducted, the tax figure inside the measure cannot be the tax the company actually paid. The tax inside NOPAT is the tax the company would pay if it carried no debt at all. Rs 2,64,00,00,000 of operating profit taxed at the assumed 25.0 per cent gives Rs 66,00,00,000, and the reduction in tax that the real interest bill produces is deliberately left out.

Where does that missing tax relief go? Not away. The relief is picked up in the rate. The cost of borrowed money is carried into the discount rate on an after-tax basis, at 6.00 per cent rather than the 8.00 per cent the company contracted, and that reduction of exactly two percentage points is the tax relief on interest being counted once, in the right place, on the other side of the fraction.

So the lenders appear twice in a complete valuation and never a third time: once inside the rate, where the cost of their money is priced, and once at the very end, where their gross debt is subtracted to move from the value of the whole business to the value of the shareholders' slice. Both of those are covered separately. The rule is that they must not also appear in the numerator.

What rate has to go with it, and why?

A rate that describes the same set of people as the cash. Matching the people to the people is the entire rule, and it is broken constantly.

Free cash flow to the firm belongs to lenders and shareholders together, so it must be discounted at a rate that blends what both groups require. For Sankalp Industrial Systems Limited that rate is the 12.00 per cent weighted average cost of capitalOne blended rate covering both groups of claimants, 12.00 per cent here., being 75.0 per cent of a 14.00 per cent cost of equity and 25.0 per cent of a 6.00 per cent after-tax cost of debtWhat borrowing costs once the tax relief on interest is counted, 6.00 per cent here.. Every one of those inputs is this worked example's own assumption, and how each one is built is covered separately; the figure is restated here rather than re-estimated.

Discount the five years at that rate and they are worth Rs 4,68,41,43,564. The discounting itself is covered separately, and the figure appears for one reason only: to show what the pairing rule produces when it is honoured.

Now break it. Take Rs 98,00,00,000, deduct the Rs 36,00,00,000 of after-tax interest that the Rs 48,00,00,000 bill becomes at the assumed 25.0 per cent rate, and discount the remainder at 12.00 per cent anyway. The lenders have now been charged twice, once in the numerator where their interest came out and once inside the rate where their money carries a 25.0 per cent weight at a 6.00 per cent cost. The result is not conservative and it is not cautious. The answer is meaningless, and no spreadsheet anywhere will object.

Why is the measure deliberately blind to how the business is funded?

Because being blind is what makes it useful. Free cash flow to the firm is capital structure neutralUnaffected by how much of the business is funded with debt.: the Rs 98,00,00,000 would be exactly Rs 98,00,00,000 if Sankalp Industrial Systems Limited carried Rs 6,00,00,00,000 of debt, or twice that, or none at all. Not one line in the build refers to borrowing. Operating profit does not, tax at a flat assumed rate does not, depreciation does not, capital expenditure does not, and the working capital movement does not.

The everyday version is a household with two neighbours who both run tailoring shops on the same street. Both take in about the same work, both pay about the same rent, both buy about the same thread. One bought her machines with a loan; the other used money she had saved. The shops produce the same cash. Who gets the cash afterwards differs. Comparing the two shops as businesses means looking at the number that comes before the loan, and that number is this one.

The blindness buys two specific things. First, the operating business can be valued once, cleanly, and the funding can be dealt with separately and later. Second, the measure strips out the one thing that was never about the operations, so two companies with the same operations and different amounts of borrowing become comparable.

The blindness also costs something, and the cost is worth naming. A company drowning in debt and a company with none show identical free cash flow to the firm, so the measure will never reveal that one of them is in difficulty. The blind spot is not a defect but a division of labour. The funding is handled where funding belongs, in the rate and at the bridge, both of which are covered separately.

What does the identity make visible about the price of growth?

The price of growth is the reason the measure is taught at all, and the short route is where the price becomes visible.

Free cash flow to the firm is NOPAT less net new invested capital. Read that as a sentence about a business rather than a formula. The company earned Rs 1,98,00,00,000 in Year 1 and kept Rs 98,00,00,000 of it. The other Rs 1,00,00,00,000 was spent, on purpose, to make next year bigger. The gap between profit and free cash flow is not leakage; it is a purchase, and this identity is the only place a reader sees the price and the thing bought in the same line.

And here what was bought can be priced exactly. Rs 1,00,00,00,000 went in and NOPAT rose by Rs 18,00,00,000 the following year. Rs 18,00,00,000 on Rs 1,00,00,00,000 is an assumed return of 18.00 per cent on new invested capital, held flat across all five years. Every year of this forecast pays the same Rs 1,00,00,00,000 and buys the same Rs 18,00,00,000 of extra profit, the cleanest possible statement of what growth costs.

Note what falls out of that. Because the price is flat and the profit is rising, the share of profit going into the ground falls every year: 50.51 per cent of NOPAT in Year 1, then 46.30, 42.74, 39.68 and 37.04 per cent in Year 5. The company is not reinvesting less. The company is earning more against the same bill.

What is the difference between this and the cash flow a company reports?

Three specific things differ, and none of the three is a rounding. The temptation to open a set of published accounts, find the operating cash flowThe reported statement figure, struck on a different basis from this measure. line and treat it as free cash flow to the firm is enormous, and it costs a beginner an afternoon every time.

First, a reported operating cash flow is struck after interest paid in most presentations. So it is already a partly post-financing figure, and free cash flow to the firm is not. Starting from it means the lenders have already been paid once before the calculation has begun.

Second, a reported figure carries the movement in every working capital account exactly as it actually happened in that year, including a customer who paid late in March and a supplier who was settled early. The forecast here holds net working capital at a modelled 15.0 per cent of revenue, producing Rs 18,00,00,000 a year and no noise at all. One is a record and the other is a rule.

Third, and most simply, a reported operating cash flow sits entirely before capital expenditure. The reported figure is not free of anything. Sankalp Industrial Systems Limited would still have Rs 1,34,80,00,000 of Year 1 spending ahead of it. The two are not the same object and one is not an approximation of the other.

What does it mean when free cash flow is low in a year the company did well?

Low free cash flow usually means the company is growing, and reading it as weakness is the single most common mistake made with this measure.

Year 1 free cash flow to the firm is Rs 98,00,00,000 against EBITDA of Rs 3,16,80,00,000. One over the other gives a cash conversionCash produced as a share of profit, 30.9 per cent of EBITDA here in Year 1. of 30.93 per cent, printed 30.9. An analyst who sees that figure and nothing else will call the cash generation poor, and will sound confident doing it.

Now look at where the rest went. Rs 66,00,00,000 to tax, at the company's own assumed effective rate. Rs 1,34,80,00,000 to capital expenditure, against depreciation of only Rs 52,80,00,000, so Rs 82,00,00,000 of that is capacity which did not exist before. Rs 18,00,00,000 into working capital, to carry the stock and the receivables that Rs 1,20,00,00,000 of new revenue needs. Add the four and they come back to Rs 3,16,80,00,000 exactly. Nothing went missing.

The conversion ratio on its own supports no conclusion about anything. Low free cash flow here is a company converting Rs 1,00,00,00,000 a year of profit into capacity at an assumed 18.00 per cent return. A business that stopped growing tomorrow would show more free cash flow immediately, and nobody would think that was an improvement.

The test that prevents the error is short enough to keep: never read free cash flow without reading net new invested capital in the same glance. Rs 98,00,00,000 with Rs 1,00,00,00,000 of reinvestment beside it and Rs 98,00,00,000 with Rs 5,00,00,000 of reinvestment beside it are completely different facts about completely different businesses, and it is the second one that gives cause for concern.

Work the second one out. A business producing Rs 98,00,00,000 of free cash flow while reinvesting only Rs 5,00,00,000 is earning Rs 1,03,00,00,000 of NOPAT and buying almost nothing with it. Next year will look like this year. The cash flow line looks healthier and the business is standing still. The ratio on its own gets exactly that backwards.

Is free cash flow to the firm the same as the cash in the bank at the end of the year?

No, and the two figures have nothing whatever to do with each other. Confusing the two is the failure that follows from every misunderstanding above, and it leads somewhere specific and wrong.

What is the second measure, the one belonging to shareholders alone?

The second measure is called free cash flow to equity. Free cash flow to equity answers a different question: not what the operating business produced for everybody, but what is left for shareholders once the lenders have been dealt with. The equity measure is a different claim on a different pool, and it is built by adjusting the firm measure.

The arithmetic of the forecast does not change. The rate does. Because the claimant set has shrunk to shareholders alone, the blended 12.00 per cent no longer describes the right people and the 14.00 per cent cost of equity does. The pairing rule is doing exactly the same work it did earlier, and that is why the two measures can never be swapped casually.

The bridge between the two measures, the borrowing schedule that drives it, and the fact that the two routes produce different valuations on this company for reasons worth understanding, are all covered separately.