Financial analysis : Question 1
What is the correct definition of Free Cash Flow and is it useful to compare a company's performance from one year to the next, on the basis of Free Cash Flow and the way it changes?
Free cash flow after tax measures the cash flow generated by capital employed. It is calculated as follows:
EBITDA
- Change in working capital
- Theoretical tax rate (equal to operating profit multiplied by the corporate income tax rate)
- Net capital expenditure
= After-tax free cash flow
It is difficult to use free cash flow to make comparisons year after year, especially for small and medium companies, as capital expenditures may be strong one year (due to a plant expansion for example) and weak the following years as the company will not expand its production capacity every year. Consequently free cash flow will be weak one year and stronger the following years independently of the company's performances.
For more information, see chapters 28 and 31 of the Vernimmen.
EBITDA
- Change in working capital
- Theoretical tax rate (equal to operating profit multiplied by the corporate income tax rate)
- Net capital expenditure
= After-tax free cash flow
It is difficult to use free cash flow to make comparisons year after year, especially for small and medium companies, as capital expenditures may be strong one year (due to a plant expansion for example) and weak the following years as the company will not expand its production capacity every year. Consequently free cash flow will be weak one year and stronger the following years independently of the company's performances.
For more information, see chapters 28 and 31 of the Vernimmen.