How to Calculate FCFE from CFO?
Free Cash Flow To Equity (FCFE) From the CFO can be calculated by adding Net Income & Depreciation and amortization, and deducting changes in net working capital from it.
Free Cash Flow to Equity (FCFE) from CFO
FCFE, or Free Cash Flow to Equity, is the cash flow available to equity shareholders after meeting all expenses, doing reinvestment, and paying debt holders.
FCFE can be derived from a company’s cash flow statement. FCFE can be calculated from the CFO. CFO stands for cash flow from operations. FCFE from the CFO is calculated as follows:
FCFE = CFO - FCInv + Net borrowing
FCInv is a fixed capital investment; it is also called capital expenditure. Fixed capital investment is an investment made by the company to buy physical assets such as machinery.
Where CFO is the amount of money a company receives and pays in its regular business activities/ ongoing business operations.
CFO specifically represents the cash flow generated from the firm’s core operating activities. CFO includes cash inflows and outflows directly related to the day-to-day business operations, and it does not include financing or investing activities.
CFO can be calculated as follows:
CFO = Net income + Depreciation and Amortization - Change in working capital
Where,
- Change in working capital = Ending working capital - Beginning working capital
- Working capital = Current assets - Current liabilities
Fixed capital investment (or FCInv or capital expenditure) is the percentage of a firm's total capital that is invested in physical assets such as factories, vehicles, machinery, etc.
Net borrowing is the difference between the amount borrowed and the amount repaid. If the amount borrowed is less than the amount repaid, then the net borrowing will be negative, indicating that the firm has no borrowing/paid off all borrowing.
Net borrowing = Amount borrowed - Amount repaid
Key Takeaways
- FCFE is free cash that is available to a firm's equity shareholders after paying all expenses and meeting all liabilities.
- FCFE can be calculated based on cash flow from operations.
- Cash flow from operations (CFO) is cash inflow and cash outflow during regular business courses.
- CFO calculation depends on net income, depreciation, amortization, and change in working capital.
- The formula for calculating FCFE from CFO includes CFO, FCInv, and Net borrowing.
- We can use this FCFE to find the equity value per share. This value can be calculated using a discounted cash flow model/constant growth model, where cash flow is in FCFE.
Examples of How to Calculate FCFE from CFO
Let us understand the concept clearly by looking at a few examples below:
Example 1. Suppose you are provided with the following information:
| Particulars | Amount |
|---|---|
| Net Income | $2,000,000 |
| Deprecation | $10,000 |
| Amortization | $5,500 |
| Ending Working Capital | $90,000 |
| Beginning Working Capital | $50,000 |
| FCInv | $1,005,000 |
| Amount Borrowed | $750,000 |
| Amount Repaid | $250,000 |
We need to calculate the following:
1. CFO
CFO = Net income + Depreciation and Amortization - Change in working capital
= $2,000,000 + $10,000 + $5,500 - $40,000 = $1,975,500
Therefore,
Change in working capital = $90,000 - $50,000 = $40,000
2. Net borrowing
Net borrowing = Amount borrowed - Amount repaid
= $750,000 - $250,000 = $500,000
3. FCFE
FCFE = CFO - FCInv + Net borrowing
= $1,975,500 - $1,005,000 + $500,000 = $1,470,500
Let us take another example
We are provided with the following data:
| Particulars | Amount |
|---|---|
| Net Income | $5,000,000 |
| Depreciation & Amortization | $4,000 |
| Beginning Current Assets | $70,000 |
| Beginning Current Liabilities | $50,000 |
| Ending Current Assets | $100,000 |
| Ending Current Liabilities | $60,000 |
| FCInv | $450,000 |
| Net Borrowings | $250,000 |
We need to calculate:
1. Ending working capital
Ending working capital = Ending current assets - Ending current liabilities
= $100,000 - $60,000 = $40,000
2. Beginning working capital
Beginning working capital = Beginning current assets - Beginning current liabilities
= $70,000 - $50,000 = $20,000
3. Change in working capital
Change in working capital = Ending working capital - Beginning working capital
= $40,000 - $20,000 = $20,000
4. CFO
CFO = Net income + Depreciation and Amortization - Change in working capital
= $5,000,000 + $4,000 - $20,000 = $4,984,000
5. FCFE
FCFE = CFO - FCInv + Net borrowing
= $4,984,000 - $450,000 + $250,000 = $4,784,000
Moving forward with example 3. We have the following information:
| Particulars | Amount |
|---|---|
| CFO | $3,568,000 |
| FCInv | $700,000 |
| Net Borrowings | $200,000 |
Calculate FCFE
FCFE = CFO - FCInv + Net borrowing
= $3,568,000 - $700,000 + $200,000 = $3,068,000
Lastly, let’s take Example 4.
| Particulars | Amount |
|---|---|
| CFO | $500,000 |
| FCInv | $7,000,000 |
| Amount Borrowed | $50,000 |
| Amount Repaid | $70,000 |
We need to calculate:
1. Net borrowing
Net borrowing = Amount borrowed - Amount repaid
= $50,000 - $70,000 = -$20,000
2. FCFE
FCFE = CFO - FCInv + Net borrowing
= $500,000 - $7,000,000 + (-$20,000) = -$6,520,000
Interpreting CFO, FCInv, Net borrowing, and FCFE
CFO is a core cash flow measure considered by investors prior to investing in any firm.
A higher CFO is considered good as it indicates that the company has more cash inflow from daily operations and less cash outflow required for operating daily.
CFO is influenced by net income, depreciation, amortization, and change in working capital.
| Variable | Increase/Decrease In Variable | Impact on FCFE and Explanation |
|---|---|---|
| Net Income | Increase | Increase FCFE as CFO will increase because of an increase in net income |
| Decrease | Decrease FCFE as CFO will decrease because of a decrease in net income | |
| Depreciation | Higher depreciation | Increase FCFE as CFO adds depreciation (Noncash expense) |
| Lower depreciation | Decrease FCFE as CFO will decrease by depreciation amount | |
| Change in working capital | Positive change in working capital | Decrease FCFE as ending working capital will be greater than beginning working capital, and this would reduce CFO |
| Negative change in working capital | Increase FCFE as ending working capital will be less than beginning working capital, and this would increase CFO | |
| CFO | Increase in CFO | Increase FCFE as the higher the CFO, the higher the FCFE |
| Decrease in CF | Decrease FCFE as CFO and FCFE are positively correlated | |
| FCInv | Increase in FCInv | Decrease FCFE as less cash will be available to equity holders after buying assets |
| Decrease in FCInv | Increase FCFE as more cash will be available to equity holders after buying fewer assets | |
| Net borrowing | Increase in net borrowing | Increase FCFE as the net amount borrowed will be greater than the amount repaid to debtholders |
| Decrease in net borrowing | Decrease FCF as the net amount borrowed will be less and the amount repaid will be more. |
Usage of FCFE and CFO
FCFE can be used in discounted cash flow models, where cash flow (CF) = FCFE.
Let’s consider an example below:
Suppose you are provided with the following information:
| FCFE in Year 1 | $250,000 |
| FCFE in Year 2 | $400,000 |
| FCFE in Year 3 | $440,000 |
| Cost Of Equity = Discount Rate (DR) | 0.08 |
Calculate the value of equity based on the DCF model where CF = FCFE.
Formula:
Value of equity = (FCFE in year 1/ (1 + DR)^1) + (FCFE in year 2/ (1 + DR)^2) + (FCFE in year 3/ (1 + DR)^3)
Value of equity = $250,000/ ( 1+ 0.08)^1 + $400,000/ (1 + 0.08)^2 + $440,000/ (1 + 0.08)^3
= $231,481 + $342,935 + $349,286 = $923,702
Value on per share basis = Value of equity/ Number of shares outstanding
Value per share if 100,000 shares are outstanding, $923,702/100,000 = 9.24 per share
FCFE can be used in a constant growth model as follows:
Let’s take an example:
- FCFE in year 1 = $250,000
- Constant growth rate = 0.05
- Cost of equity = 0.10
Value, according to the constant growth model, is
Value of equity = FCFE in year 1/(Cost of equity - Constant growth rate)
Value of equity = $250,000/ (0.10 - 0.05) = $5,000,000
Value per share if 1,000,000 shares are outstanding will be $5,000,000/1,000,000 = $5 per share
FCFE can be used in ratios as follows,
Let us take another example:
Find the price/cash flow ratio, where cash flow = FCFE, Given below details
| Price Per Share | $4 |
| FCFE Per Share | $20 |
Price per share/FCFE per share
= $4/$20 = 0.2
FCFE can be used to find the value of equity, which can then be used to determine the value of a firm. Consider the following example:
Value of equity (Based on FCFE) = $5,000,000 and Debt value = $1,250,000, the value of the firm is,
Value of firm = Value of equity + Debt value
Value of firm = $5,000,000 + $1,250,000 = $6,250,000
CFO is also a cash flow and can be used in the discounted cash flow model, constant growth model, and ratio analysis.
How To Calculate FCFE From CFO FAQs
Yes, FCFE calculated from CFO can be negative.
A negative FCFE from CFO can be interpreted as no free cash flow available for the firm's equity holders.
This statement is false because even if CFO is negative, other variables, such as a positive net borrowing, would lead to a positive FCFE.
Net borrowing is calculated as the amount borrowed minus the amount repaid. Suppose the amount borrowed is greater than the amount repaid.
In that case, the result will be a positive net borrowing and increase in FCFE because a higher amount borrowed than the amount repaid will increase the free cash flow that is available to equity holders in the current period.
In subsequent periods FCFE will be lower because there will be additional interest payments associated with the additional amount that is borrowed, this payment will be made to debt holders, and the amount of cash that will be available for equity holders will decrease in subsequent periods.
Therefore, a positive net borrowing added to FCFE will increase FCFE in the current period.
Whereas, if the amount borrowed is less than the amount repaid, then the result would be a negative net borrowing that will decrease FCFE because more amount is repaid to the debt holders than the amount borrowed from the debt holders (more cash outflow than cash inflow), so free cash flow that will be available to equity holders will be less.
FCInv is capital expenditures, and expenses should be subtracted from FCFE to know the amount of FCFE that is available to equity holders.
CFO is added to FCFE because it's a cash flow after considering daily cash outflows and inflows. Its net cash flow is available after meeting daily expenses, so the CFO should be added to FCFE.
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