Question

Free cash flow (FCF) is the basis for determining the value of an investment and this is very much so when determining the value of a company. Explain why we can’t rely on Net Income as the basis for valuing a company and how we start with Net Income from the Income Statement eventually arrive at FCF.  

Answer 1

Free Cash flow(FCF) is the cash a company produces through its opertion,less the cost of expenditure on assets.

It is the cash left over after a company pays for its operating expenses and capital expenditure,also known as CAPEX.

Unlike net income,free cash flow is a measure of profitability that excludes the non-cash expenses and include spending on equipment and assets and as well as changes in working capital.Because Free cash flow accounts for change in working capital,it can provide important insights into the value of company.FCF shows whether a company have  enough cash after funding operations an capital expeditures,to pay investors through dividend and shares buyback.Therefore we use FCF to estimate the value of comapny.

FCF can be calculated as follows

	Net income
ADD:	Non cash expenses(eg.Depreciation)
ADD:	Decrease in Working Capital(i.e.Current assets-current liablities)
LESS:	Increase in Working Capital(i.e.Current assets-current liablities)
LESS:	Capital expenditure
=	Free Cash flow