FCFF represents the cash flow that is available to all of the providers of capital to the firm, including equity holders and debt holders.
To calculate FCFF, we start with the operating cash flow (OCF), which is the cash flow generated by a company's core operations. OCF is calculated as follows:
OCF = EBIT(1 - tax rate) + depreciation and amortization - change in non-cash working capital
EBIT is earnings before interest and taxes, which is a measure of a company's profitability before taking into account financing and tax expenses. Depreciation and amortization are non-cash expenses that are added back to EBIT to reflect the fact that these expenses do not represent cash outflows.
Non-cash working capital refers to the funds that a company has tied up in its current assets, such as inventory and accounts receivable, minus the funds that it has tied up in its current liabilities, such as accounts payable.
Changes in non-cash working capital can have a significant impact on a company's cash flow, as they reflect the timing differences between when a company pays its suppliers and when it receives payment from its customers. If a company's non-cash working capital increases, it means that the company is tying up more cash in its operations, which reduces the amount of cash that is available to distribute to its providers of capital.
To arrive at FCFF, we need to deduct two types of cash outflows: capital expenditures (CAPEX) and changes in net working capital (NWC).
CAPEX represents the funds that a company spends on fixed assets, such as property, plant, and equipment, which are used to generate revenue over a long period of time. Although CAPEX is an expense that reduces profits, it does not necessarily represent a cash outflow in the current period. This is because companies often pay for CAPEX over time, using funds that were generated in previous periods or by issuing debt or equity. However, CAPEX does represent a cash outflow that reduces the amount of cash that is available to distribute to the providers of capital.
Changes in net working capital (NWC) also represent a cash outflow that reduces the amount of cash that is available to distribute to the providers of capital. NWC is calculated as follows:
NWC = current assets - current liabilities
If NWC increases, it means that a company is tying up more cash in its current assets, such as inventory and accounts receivable, which reduces the amount of cash that is available to distribute to its providers of capital.
Conversely, if NWC decreases, it means that a company is releasing cash from its current assets, which increases the amount of cash that is available to distribute to its providers of capital.
In summary, we deduct CAPEX and changes in net working capital to arrive at FCFF because these represent cash outflows that reduce the amount of cash that is available to distribute to the providers of capital. By deducting these cash outflows from the operating cash flow, we arrive at FCFF, which represents the cash flow that is available to all of the providers of capital to the firm.