Free cash flow (FCF) as a proxy for management performance

Recall that free cash flow (FCF) can be calculated in various ways, depending on audience and available data.

A common measure is to take the earnings before interest or taxes (EBIT) multiply by (1 – tax rate) ; add back depreciation and amortization expense; then subtract out changes in working capital (Current Assets-Current Liabilities) and capital expenditures (CAPEX) (see the below table for example sources of the components of the equation).  Depending on the target audience for a FCF conversation, a number of refinements and adjustments may also be made to try to eliminate undesirable distortions.

FCF =  (EBIT * (1 – marginal tax rate)) + (Depreciation & amortization) – (Changes in Working Capital) – (CAPEX)

So, for example (for illustration only; use your numbers of course)

EBIT = $500,000

Marginal tax rate = 35%

Depreciation/amortization = $600,000

Changes in working capital = $400,000

CAPEX = $250,000

Then,

FCF = $500,000 * (1 – 0.35) + $600,000 – $400,000 – $250,000

= $325,000 + $600,000 – $400,000 – $250,000

= $275,000

Element                                                Source

EBIT                                                     Current Income Statement

Tax rate                                                Current Income Statement

Depr/amort                                         Current Income Statement

Changes in working capital              Balance sheet (specifically, Current Assets and Current Liabilities)

CAPEX                                                  Balance sheet (specifically, Property, Plant and Equipment)

Is FCF the only metric that a banker uses for managerial effectiveness? Of course not! There are other qualitative measures.

Whether you bootstrap your business (you don’t use other people’s money or “OPM” to grow your business) or use debt or equity to grow your business, FCF is a VERY important metric to the various stakeholders.

How could you use FCF? It starts with the calculation and the trend line going forward. In other words, is your FCF position strengthening or weakening over time? A relatively easy calculation for your accountant, CPA or bookkeeper. I would encourage you to get started.