FCFE : Free Cash Flow to Equity Meaning

To ensure a steady source of income, most people invest in the stock exchange. Businesses that pay dividends to shareholders are often profitable. It is possible to determine if a company's financial statements are accurate and check its free cash flow. After all operations expenses are paid, free cash flow refers to the company's surplus cash. However, there's another aspect to investments that is equally important - free cash flow from equity. This guide will help you to understand it.

What's free cash flow to equity?

The term free cash flow to equity (also known as FCFE) is a corporate finance term that simply refers to the amount of cash that a company's equity shareholders can receive in stock buybacks and dividends. After all expenses have been paid, such as meeting all operational requirements, capital expenditure, reinvesting in the company and paying off any outstanding debts, this amount can be calculated. FCF to equity can also be referred to as 'leveraged-free cash flow', 'flow to equity', or FTE. Dividends are cash flows that are paid to shareholders, but FCF to equity is the cash flow available to pay dividends.

Equity Formula Cash flow from Equity Formula

You can find the statement of cash flows on the company's website to determine its FCFE details. Many companies send out financial statements quarterly, semi-annually or annually. The FCFE can be calculated using the free cash flow formula.

FCFE = cash from operating activities - capital Expenditures + net debt issued (repaid)

Equity calculation: How it works

FCFE is a combination of net income, working capital, capital expenditures, and debt. You will need to be able to read and understand the financial statements of the company in order to calculate FCFE. These are the places you will find these details in financial statements.

1. The income statement of the company will show the net income.

2. The cash flow statement, which is located under the heading 'cashflows from investing', contains details about capital expenditure.

3. The cash flow statement, under the section titled "cash flows from operations", also lists details about working capital. Working capital is generally defined as the difference between a company’s most recent assets, and its liabilities.

4. Many companies have short-term capital requirements, which are often related to their immediate operations. These are also known as net borrowings and debts. You can see the details in the section titled 'cash flow from financing' on the cash flow statement. You don't have to add back interest costs because they are already included under the net income section.

Analysis of equity valuations and cash flows - What it tells

When determining the company's worth, financial analysts often use the free cashflow to equity metric. This valuation method was popularized because it was considered an alternative to or replacement for the Dividend Discount Model (DDM) in cases where certain companies didn't pay dividends to shareholders. The FCFE model does not equal the amount paid to shareholders. Analysts use the free cashflow to equity formula to determine if stock repurchases or dividend payments are funded with FCFE, other financing sources, and vice versa. Investors want to see dividend payments and share repurchases that are fully funded with free cash flow.

Important factors to consider when analysing FCFE

When analysing FCFE, there are three important factors you need to consider. These are the following:

1. If the FCFE is less than the cost of buying back shares or making dividend payments, this indicates that the company is likely being funded from existing capital (including retained earnings and debt) or is issuing securities. This is something that you do not want to see in any investment. Analysts may suggest that it could be a good idea to take on debt to fund share repurchases. This is especially true if shares are traded at discount rates. This should only be considered if shares of the company rise in the future.

2. If the company's dividend payment funds are significantly lower than the free cash flow to equity it could be an indication that the company is using the cash to grow its cash reserves. It could also invest in marketable securities.

3. Finally, if the company spends funds to pay dividends and buy back shares and it is approximately equal to the FCF, it is a sign that the company is doing well and is paying all its investors.

What's a negative FCFE?

FCFE can be either positive or negative. This is an important fact. If a company has a negative FCFE, it may be in need of funds or new equity. This could happen immediately or very soon. Before you invest, there are several ways to determine if a company is prone to negative FFE. These are:

1. It is a sign of a negative FCFE if you see a significant negative net income in your financial statements.

2. In their early years, growth companies have many needs, such as significant capital expenditure, reinvestment, and hiring. This can lead to a reduction in net income and a negative FCFE.

3. If you observe that a company invests a lot of money in one year and little in the next, the FCFEcould be negative during the reinvestment period but positive in other years.

Conclusion

You now have a better understanding of financial statements because you are familiar with FCFE.