FINANCE · CASH FLOW AND VALUATION
Free Cash Flow: FCFF vs. FCFE, Formulas, and Worked Example
Free cash flow measures cash remaining after specified operating and investment needs. The definition matters: free cash flow to the firm (FCFF) is available to debt and equity capital providers together, while free cash flow to equity (FCFE) reflects financing flows and the cash available to shareholders. ← Finance hub · Cash-flow statement · WACCAlways name the measure. “Free cash flow” alone can mean different things. State the formula, treatment of interest, working-capital definition, and investment deductions before comparing businesses.
FCFF and FCFE answer different questions
| Measure | Capital providers | Debt financing treatment | Valuation discount rate |
|---|---|---|---|
| FCFF | Debt and equity together | Before interest and principal financing flows | Appropriate WACC |
| FCFE | Equity shareholders | After interest, including net borrowing | Appropriate cost of equity |
| Operating cash flow minus capital expenditure | Depends on the operating cash-flow definition | May include paid interest but excludes financing borrowings | Do not assign a rate until the definition is reconciled |
The core formulas
For a simplified operating business with ordinary interest-bearing debt: FCFF = EBIT × (1 − T) + depreciation and amortization − capital expenditure − increase in operating net working capital FCFE = net income + depreciation and amortization − capital expenditure − increase in operating net working capital + net borrowing FCFE = FCFF − interest × (1 − T) + net borrowing Here EBIT is operating profit before interest and tax. Net borrowing means new debt proceeds less principal repaid. An increase in operating working capital is a cash use; a decrease releases cash. Other noncash items, taxes, acquisitions, leases, and unusual transactions may need additional adjustments in an actual business.Worked example: $55,000 FCFF and $45,000 FCFE
Assume an original hypothetical annual model with EBIT of $100,000, interest expense of $20,000, and a 25% tax rate. All interest is paid and deductible, tax benefits are usable, and cash tax equals the modeled expense. Depreciation is $15,000, capital expenditure is $25,000, and operating working capital increases $10,000. The business borrows $20,000 and repays $15,000 of principal. There are no other adjustments.| Income calculation | Amount |
|---|---|
| EBIT | $100,000 |
| Interest expense | −$20,000 |
| Pretax income | $80,000 |
| Tax at 25% | −$20,000 |
| Net income | $60,000 |
| Cash-flow component | FCFF | FCFE |
|---|---|---|
| Starting profit measure | EBIT after operating tax: $75,000 | Net income: $60,000 |
| Add depreciation | +$15,000 | +$15,000 |
| Subtract capital expenditure | −$25,000 | −$25,000 |
| Subtract working-capital increase | −$10,000 | −$10,000 |
| Add net borrowing | Excluded | +$5,000 |
| Free cash flow | $55,000 | $45,000 |
Reconcile to the cash-flow statement
Assume paid interest is included in operating cash flow. In this example, operating cash flow is $60,000 + $15,000 − $10,000 = $65,000. Subtracting $25,000 capital expenditure gives $40,000. Adding $5,000 net borrowing produces FCFE of $45,000. To move from that operating cash flow to FCFF, add after-tax interest of $15,000 and subtract capital expenditure: $65,000 + $15,000 − $25,000 = $55,000. If interest is classified elsewhere in the reported cash-flow statement, reconcile its treatment first. Do not add it back twice.Define operating working capital carefully
A useful simplified definition is accounts receivable plus inventory and other operating current assets, less accounts payable and other operating current liabilities. Exclude excess cash and interest-bearing debt from this operating measure. Cash and debt have separate roles in valuation. For example, receivables rising $8,000, inventory rising $7,000, and payables rising $5,000 create a net $10,000 increase: $8,000 + $7,000 − $5,000. That is the investment deducted above. See working capital for the underlying timing.Use the measure that fits the decision
- Value operations: Discount FCFF using a risk-consistent WACC, then reconcile operating value to equity value.
- Value equity directly: Discount FCFE using a suitable cost of equity and a consistent financing forecast.
- Plan liquidity: Build a three-statement forecast and payment schedule. Annual free cash flow can hide a short-term shortage.
- Compare performance: Normalize definitions before comparing free cash flow across companies or years.
Common mistakes
EBITDA is not free cash flow: it leaves out taxes, investment, and working-capital needs. Depreciation is added back because it is noncash, but replacement assets still cost money. Negative free cash flow may reflect growth investment or weak operations; determine which. Borrowing can increase FCFE in the period without improving operating performance, and future debt service must still be modeled.Frequently asked questions
Is FCFE the same as dividends?
No. FCFE estimates cash available to equity under the specified model. Actual dividends depend on reserves, financing terms, legal restrictions, and management’s decisions.Can FCFF be positive while FCFE is negative?
Yes. Significant interest and principal repayments can absorb cash generated by operations after investment. The financing schedule explains the difference.What comes next?
Use free cash flow as the input to a DCF valuation, and test assumptions with sensitivity and scenario analysis.For borrowing, repayment, and ownership choices, continue to Capital Structure: Debt vs. Equity Financing.