Financial analysis can often seem like a dizzying maze of formulas and metrics. Each number clamoring for its importance in your analysis process—and yes, they are all important for the most part.
But a lot of the numbers we see in these evaluations are “top-of-the-line” in nature. We often don’t get to see their practical, real-life value when they’re put to use. This is an important thing for analysts to be able to uncover, especially when it involves evaluating M&A deals.
Investors need to know the real value of a company, and the meaning of these numbers. That’s why downstream, distilled financial metrics exist, and exactly why we’re delving into them in this series.
Today, we’re diving into free cash flow to equity (FCFE). It’s a metric that reveals how much cash a company can return to its shareholders after taking care of its business needs.
What Is Free Cash Flow to Equity?
At its core, FCFE represents the cash that’s available to equity shareholders after all operating expenses, taxes, net debt repayments, and capital expenditures. In other words, it’s the money left over after the company has taken care of business, literally.
Here’s Why FCFE Matters
- Cash Flow to Owners: Unlike free cash flow to the firm (FCFF), which is all about the company’s value as a whole, FCFE zeroes in on the equity holders. It’s the cash flow available to those who own a piece of the pie after creditors.
- Performance Indicator: FCFE is a strong indicator of a company’s ability to generate cash for equity holders. It helps to assess the company’s long-term financial health.
- Valuation Tool: Investors use FCFE in discounted cash flow (DCF) models to value a company from an equity holder’s perspective.
What Is the Formula for FCFE?
The formula for calculating FCFE might look intimidating at first glance. However, it simply breaks down the company’s financial flows:
FCFE = Net Income + Depreciation − Capital Expenditures − Change in Working Capital + Net Borrowing
- Net Income: The bottom line, or what the company makes after all expenses.
- Depreciation: The reduction in the value of assets over time. For free cash flow, you add it back because it’s a non-cash expense.
- Capital Expenditures (CapEx): Investments in fixed assets like buildings or machinery.
- Change in Working Capital: The difference in current assets and liabilities from one period to the next.
- Net Borrowing: Any debt taken on or paid off during the period.
FCFE Example
Imagine Company X has a net income of $500,000, depreciation of $50,000, capital expenditures of $200,000, a working capital increase of $30,000, and net borrowing of $100,000.
You’d calculate the FCFE as follows:
FCFE = $500,000 + $50,000 − $200,000 − $30,000 + $100,000 = $420,000
This $420,000 represents the cash available to equity holders after all obligations are met.
What Role Does FCFE Play in the World of M&A?
In high-stakes ventures, like in the world of mergers and acquisitions (M&A), FCFE is a valuable metric for buyers and sellers. It helps determine how much cash a company can generate for its shareholders. This is crucial in valuing the business. Understanding FCFE can make or break a deal when evaluating a potential acquisition.
Here’s Why:
- Valuation Insight: FCFE provides a measure of the cash flow that will be available to the new owners after covering all expenses and debt obligations.
- Investment Decision: Investors and acquirers use FCFE to assess whether the returns justify the investment. It’s a key factor in determining whether the deal will be profitable in the long run.
- Debt Management: FCFE highlights how well a company can manage its debt. This is critical when you’re thinking of taking on liabilities through an acquisition.
What FCFE Shows Stakeholders
For stakeholders, FCFE is more than just a number. It’s a window into the financial health of the company. Here’s what it reveals:
- Profitability: FCFE shows whether a company is generating enough cash to cover all expenses and still has something left for shareholders.
- Debt Capacity: It helps when planning how much debt the company can handle without jeopardizing shareholder returns.
- Sustainability: FCFE provides insight into the company’s ability to sustain its operations and return value to shareholders over time.
By analyzing FCFE, stakeholders can better understand the long-term financial viability of a company. They can use this insight to steer their strategies.
FCFE Key Takeaways
FCFE isn’t just another financial metric—it’s the heartbeat of a company’s cash flows. It gives a practical view of a company’s capacity to do work and produce profits.
Whether you’re a shareholder, a prospective buyer, or a company executive, understanding FCFE can help you make smarter financial decisions. Here’s a recap of what we’ve reviewed:
- What is FCFE? FCFE is the cash available to shareholders after a company pays its operating expenses, capital expenditures, and debt obligations. It measures how much money can be returned to the business’s owners.
- The Relevance of FCFE in M&A: In mergers and acquisitions, FCFE helps buyers and sellers evaluate the cash flow potential of a business. It’s key to assessing whether an acquisition is financially sound and can provide the expected returns.
- How Advisors Can Help: Expert advisors can assist in leveraging FCFE during M&A dealmaking. Their expertise can help you include more factors and make better decisions when pursuing deals.
We hope that you’ve found this article valuable when it comes to learning about free cash flow to equity (FCFE). If you’re interested in reading more, please subscribe below to get alerted of new articles as we write them.
