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We know that cash flows are a key driver for value creation. But what do we mean by cash flows? Cash flows could mean different things in different contexts! For example: Cash flows will indicated different things in a cash flow statement presented in a financial statement and in a DCF valuation? Even within a DCF valuation cash flows will mean different things when valuing the firm and valuing the equity. So here we dig deeper into what cash flows mean with specific emphasis on Free Cash Flow to Equity vs. Free Cash Flow to the Firm.

Essentially cash flows refer to the cash generated in the business during a specific time period after meeting all business obligations.  This cash flow is often referred to as ‘free cash flow’ indicating that the business has met all its obligations (operating payments and capital expenditure payments) and the business is free to do whatever it pleases with this cash flow.

Understanding what free cash flow does not mean will help you understand what it means.

  • Free cash flow does not equal the cash flow from operating activities. We have to consider the reinvestment needs of the business.
  • Free cash flow is not equal the cash left over at the end of a period. This is what is reflected in the balance sheet. The cash reflected in the balance sheet could have been generated over many periods or may have been raised as debt or new equity and is not the cash flow generated by the business during a specified period.

Free cash flow is the cash generated in the business during a specific time period after meeting all business obligations. Now that you have a better understanding of what free cash flows are, you must know that there are multiple types of free cash flows in the business world. The cash flow statements presented by companies as part of their financial statements categorizes cash flow statements into three types:

  • Cash flows from operating activities;
  • Cash flows from investing activities; and
  • Cash flows from financing activities.

This is not what is relevant in the world of corporate finance nor is it appropriate when valuing an asset using the DCF valuation method. In the world of corporate finance, there are two types of free cash flow:

  • Free cash flow to the firm; and
  • Free cash flow to equity.

Free Cash Flow to the Firm (FCFF)

The free cash flow to the firm (FCFF) is the cash flow available to the entire firm before any payments are made to the providers of capital (both debt and equity). Specifically, this is the free cash flow to the firm assuming that the business is fully funded by equity. Or equivalently we can say that this is the free cash flow to the firm before any interest and debt repayments have been made even if the firm is funded by equity and debt.

Cash Flow to Debt

Cash flow that is paid to the providers of debt including interest, other fees and principle payments is called cash flow to debt.

Free Cash Flow to Equity (FCFE)

Free cash flow to equity is the cash flow remaining after all obligations including any interest and debt repayments have been made. Please note that in a discounted cash flow model, we will be using the free cash flow to the firm and not the free cash flow to equity.

Free Cash Flow to Equity OR Free Cash Flow to the Firm?

The key question is: When do we use the Free Cash Flow to Equity and when do we use the Free Cash Flow to the Firm? The answer depends on what you are valuing. If you are valuing the firm as a whole, you will use the free cash flow to the firm (FCFF). If, on the other hand, you are valuing just the equity, you will use the free cash flow to equity (FCFE).