FCFF vs FCFE
Taking a closer look at the terms ‘free cash flow for the firm’ (FCFF) and ‘free cash flow to equity’ (FCFE), the part ‘free cash flow’ is common for both terms. Free cash flow refers to the amount that is left over once the capital expenses are reduced from operating cash flow. Basically, free cash flow is the funds that are left over once all payments, investments, etc. are made. Free cash flow is the funds that are left over for distribution among stockholders, bondholders, and investors. The terms FCFF and FCFE further breakdown the term free cash flow. This article offers a clear overview of what each of these terms means and how they are different to each other.
Free Cash Flow for the Firm (FCFF)
FCFF, which stands for free cash flow for the firm, is a financial performance measure that looks at the amount of cash that is generated for the firm once all expenses, taxes, changes in net working capital, and changes in investments are reduced. It is calculated as,
FCFF = Operating cash flow – expenses – taxes – changes in net working capital – changes in investments
The FCFF is the amount that is distributed among the firm’s stock and bond holders once all other outflows are reduced. Calculating the FCFF is important for any corporation since it acts as a method of determining a company’s profitability and financial stability. If the FCFF derives a plus value, the firm has a surplus after expenses are deducted and if the FCFF is a negative value this is a sign of danger that the firm does not have enough revenue to finance the expenses or investments.
Free Cash Flow to Equity (FCFE)
FCFE that stands for free cash flow to equity measures the amount that is distributed among shareholders once expenses, changes in net working capital, debt repayment are reduced and new debts are added. FCFE is calculated by,
FCFE = Net income – net capital expenses – change in net working capital + new debt – debt repayments
FCFE is important to calculate because FCFE calculation will help ascertain the value of the firm. FCFE is also used by analysts to analyze a firm’s value and can be used in place of dividends for this purpose. This is demonstrated when FCFE is used in stock valuation. In the FCFE model of stock valuation, the free cash flow to equity is used to value stock instead of dividends as in the dividends discount model.
What is the difference between FCFF and FCFE?
The two terms free cash flow for the firm (FCFF) and free cash flow to equity (FCFE) sound quite similar and can be easily confused. However FCFF is the amount that is generated for the firm once other expenses, taxes, etc. are reduced from the cash flows, and is the total amount left for distribution among stock and bond holders. FCFE, on the other hand, is the amount that is left for shareholders once debt payments, capital expenses etc. are reduced from net income.
Looking closer at the relationship of these terms, FCFF is the total amount left for both bond and stock holders, but bondholders are paid before stock holders. Once obligations to all other investors are met, and other capital expenses, working capital, and debt are reduced, we arrive at FCFE, which is the final amount left over for distribution among the final recipients; the stockholders.
Summary:
FCFF vs FCFE
• FCFF, which stands for free cash flow for the firm, is a financial performance measure that looks at the amount of cash that is generated for the firm once all expenses, taxes, changes in net working capital, and changes in investments are reduced.
• FCFE that stands for free cash flow to equity measures the amount that is distributed among shareholders once expenses, changes in net working capital, and debt repayment are reduced and new debts are added.
• FCFF is the total amount left for both bond and stock holders, but bondholders are paid before stock holders, and once debt payments, and other capital expenses and working capital are reduced we arrive at FCFE, which the final amount left over for distribution among the final recipients; the stockholders.