Save 30% on all 2023 Study Packages with Code: BLACKFRIDAY30. Valid until Nov. 28th.

FCFF and FCFE Ratios

FCFF and FCFE Ratios

The cash flow statement can be used to compute financial ratios which measure a company’s profitability, performance, and financial strength.

Other cash flow measures such as free cash flow to the firm, and free cash flow to equity, can also be instrumental in the valuation of a company and its equity securities. Generally speaking, free cash flow refers to the excess of operating cash flow over capital expenditures.

Free Cash Flow to the Firm

Free Cash Flow to the Firm (FCFF) is the cash flow that is available to a company’s suppliers of debt and equity capital after the company has paid all its operating expenses and made the required investments in fixed capital and working capital. It is computed according to the following equation:

FCFF = NI + NCC + Int(1 – Tax rate) – FCInv – WCInv

Where:

NI = Net income;

NCC = Non-cash charges;

Int = Interest expense;

FCInv = Capital expenditures; and

WCInv = Working capital expenditures.

Alternatively, it may be computed as:

FCFF = CFO + Int(1 – Tax rate) – FCInv

Where CFO represents cash flow from operating activities in the case where the interest paid is included as an operating activity.

Free Cash Flow to Equity

Free Cash Flow to Equity (FCFE) refers to the cash flow that is available to a company’s common stockholders after the company has paid all its operating expenses and borrowing costs and made the required investments in fixed capital and working capital. It is computed according to the following equation:

FCFE = CFO – FCInv + Net borrowing

If net borrowing is negative, this means that a company’s debt repayments have exceeded its receipt of borrowed funds. In this case:

FCFE = CFO – FCInv – Net debt repayment

A positive FCFE implies that a company has more operating cash flow than it needs to cover capital expenditures and the repayment of debt. Therefore, such a company has cash available for distribution to shareholders.

Cash Flow Performance and Coverage Ratios

Several ratios can be computed using the cash flow from the operating activities segment of a cash flow statement. Data gathered from the computation can be used to compare the performance and prospects of different companies within the same industry or across industries. These ratios fall into two categories: cash flow performance (profitability) ratios, and cash flow coverage (solvency) ratios.

These ratios are summarized in the following table:

$$\begin{array}{c|c|c} \textbf{Performance Ratio} & \quad \quad \quad \textbf{Calculation} \quad \quad \quad & \textbf{Indication} \\ \hline \text{Cash flow to revenue} & \cfrac {\text{CFO}}{\text{Net revenue}} & \begin{array}[t]{c} \text{Operating cash generated} \\ \text {per dollar of revenue} \end{array} \\ \hline \text{Cash return on assets} & \cfrac { \text{CFO} }{ \text{Average total assets}} & \begin{array}[t]{c} \text{Operating cash generated} \\ \text {per dollar of} \\ \text{asset investment} \end{array} \\ \hline \text{Cash return on equity} & \cfrac { \text{CFO} }{\begin{array}[t]{c} \text{Average shareholder’s} \\ \text{equity} \end{array}} & \begin{array}[t]{c} \text{Operating cash generated} \\ \text{per dollar of} \\ \text{owner investment} \end{array} \\ \hline \text{Cash to income} & \cfrac {\text{CFO}}{\text{Operating income}} & \begin{array}[t]{c} \text{Cash generated from} \\ \text{operations} \end{array} \\ \hline \text{Cash flow per share} & \cfrac {\text{CFO-Pref. dividends}}{\begin{array}[t]{c} \text{Number of common} \\ \text{shares outstanding} \end{array}} & \begin{array}[t]{c} \text{Operating cash flow on a} \\ \text{per share basis} \end{array}\\ \hline \text{Debt payment} & \cfrac {\text{CFO}}{\begin{array}[t]{c} \text{Cash paid for} \\ \text{long term debt payment} \end{array}} & \begin{array}[t]{c} \text{Ability to pay debts} \\ \text{with operating cash flows} \end{array} \\ \hline \text{Dividend payment} & \cfrac {\text{CFO}}{\text{Dividends paid}} & \begin{array}[t]{c} \text{Ability to pay dividends} \\ \text{with operating cash flows} \end{array} \\ \hline \text{Investing and financing} & \cfrac {\text{CFO}}{\begin{array}[t]{c} \text{Cash outflows for} \\ \text{Inv. and Fin. activities} \end{array}} & \begin{array}[t]{c} \text{Ability to acquire assets,} \\ \text{pay debts, and make} \\ \text{distributions to owners} \end{array} \\ \hline \text{Debt coverage} & \cfrac {\text{CFO}}{\text{Total debt}} & \begin{array}[t]{c} \text{Financial risk and} \\ \text{financial leverage} \end{array} \\ \hline \text{Interest coverage} & \cfrac { \begin{array}[t]{c} \text{CFO + Interest paid} \\ \text{+ Taxes paid} \end{array}}{\text{Interest paid}} & \begin{array}[t]{c} \text{Ability to meet} \\ \text{interest obligations} \end{array} \\ \hline \text{Reinvestment} & \cfrac {\text{CFO}}{\begin{array}[t]{c} \text{Cash paid for} \\ \text{long term assets} \end{array}} & \begin{array}[t]{c} \text{Ability to acquire} \\ \text{assets with} \\ \text{operating cash flows} \end{array} \\ \end{array} $$

Question 1

Which of the following statements accurately describes free cash flow to the firm (FCFF)?

  1. Cash flow that is available to a company’s suppliers of debt capital after the company has paid all its operating expenses and made necessary investments in fixed and working capital.
  2. Cash flow that is available to a company’s suppliers of debt and equity capital after the company has paid all its operating expenses and made necessary investments in fixed and working capital.
  3. Cash flow that is available to a company’s common stockholders after the company has paid all its operating expenses and borrowing costs and made necessary investments in fixed and working capital.

Solution

The correct answer is B.

Free cash flow to the firm (FCFF) is the cash flow that is available to a company’s suppliers of debt and equity capital after the company has paid all its operating expenses and made necessary investments in fixed and working capital. Option B describes free cash flow to equity (FCFE). Option C is partially correct, but inaccurately excludes suppliers of equity capital in its definition.

Question 2

U&U Ltd. reported the following information in its latest financial reports:

Beginning borrowing balance: $200,000

Ending borrowing balance: $250,000

Cash from operations: $500,000

Fixed capital investment: $100,000

U&U’s free cash flow to equity (FCFE) is closest to:

  1. $50,000
  2. $150,000
  3. $550,000

Solution

The correct answer is C.
$$\text{FCFE =
Cash from operations
– Fixed capital investment
+ Net borrowing}$$

Where: 
$$\begin{align}\text{Net borrowing}& = \text{Ending borrowing balance – Beginning borrowing balance}\\ & = $250,000 – $200,000 = $50,000\\  \Rightarrow \text{FCFE} &= $500,000 – $100,000 + $50,000 = $450,000 \end{align}$$

Shop CFA® Exam Prep

Offered by AnalystPrep

Featured Shop FRM® Exam Prep Learn with Us

    Subscribe to our newsletter and keep up with the latest and greatest tips for success
    Shop Actuarial Exams Prep Shop GMAT® Exam Prep


    Sergio Torrico
    Sergio Torrico
    2021-07-23
    Excelente para el FRM 2 Escribo esta revisión en español para los hispanohablantes, soy de Bolivia, y utilicé AnalystPrep para dudas y consultas sobre mi preparación para el FRM nivel 2 (lo tomé una sola vez y aprobé muy bien), siempre tuve un soporte claro, directo y rápido, el material sale rápido cuando hay cambios en el temario de GARP, y los ejercicios y exámenes son muy útiles para practicar.
    diana
    diana
    2021-07-17
    So helpful. I have been using the videos to prepare for the CFA Level II exam. The videos signpost the reading contents, explain the concepts and provide additional context for specific concepts. The fun light-hearted analogies are also a welcome break to some very dry content. I usually watch the videos before going into more in-depth reading and they are a good way to avoid being overwhelmed by the sheer volume of content when you look at the readings.
    Kriti Dhawan
    Kriti Dhawan
    2021-07-16
    A great curriculum provider. James sir explains the concept so well that rather than memorising it, you tend to intuitively understand and absorb them. Thank you ! Grateful I saw this at the right time for my CFA prep.
    nikhil kumar
    nikhil kumar
    2021-06-28
    Very well explained and gives a great insight about topics in a very short time. Glad to have found Professor Forjan's lectures.
    Marwan
    Marwan
    2021-06-22
    Great support throughout the course by the team, did not feel neglected
    Benjamin anonymous
    Benjamin anonymous
    2021-05-10
    I loved using AnalystPrep for FRM. QBank is huge, videos are great. Would recommend to a friend
    Daniel Glyn
    Daniel Glyn
    2021-03-24
    I have finished my FRM1 thanks to AnalystPrep. And now using AnalystPrep for my FRM2 preparation. Professor Forjan is brilliant. He gives such good explanations and analogies. And more than anything makes learning fun. A big thank you to Analystprep and Professor Forjan. 5 stars all the way!
    michael walshe
    michael walshe
    2021-03-18
    Professor James' videos are excellent for understanding the underlying theories behind financial engineering / financial analysis. The AnalystPrep videos were better than any of the others that I searched through on YouTube for providing a clear explanation of some concepts, such as Portfolio theory, CAPM, and Arbitrage Pricing theory. Watching these cleared up many of the unclarities I had in my head. Highly recommended.