Using free cash flow to equity (FCFE), you can measure a company's ability to pay dividends to shareholders, secure additional debt, and increase investment in the business. FCFE reflects cash available to common stockholders after deducting the calculated operating costs, taxes, debt payments, and expenses required to maintain production. A company's FCFE can describe the company's strengths or weaknesses as well as its ability to generate sustainable income. FCFE is calculated by examining various accounts on the Balance Sheet or Statement of Financial Position to obtain an accurate assessment of the company's cash flows.
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Part 1 of 2: Understanding FCFE
Step 1. Learn the basics of FCFE calculation inputs
There are several general formulas for determining FCFE numbers, but within these formulas, various analysts have debated about which input to choose when interpreting the data. Since FCFE represents cash after deducting expenses, payments and “expenses required to continue production”, you need to determine which of these “expenses” are classified. Think of your life as an example to make it easier to understand..
- For example, if you tabulate your personal income over a three-month period, you earn quarterly earnings. Now, if you want to know the FCFE available at the end of this period, we will subtract your income by your expenses.
- Rent and mortgage payments, debt payments, taxes, and other similar expenses are fixed. If you continue to operate, these expenses will continue to be paid. Thus, these expenses need to be taken into account to reduce income.
- However, sometimes an account is part of the profit capability for a particular business unit. The tricky part is when we focus on the “expenses” to keep production going.
- For example, imagine the cost of your gym membership. If you're a dentist, working out at the gym is an option, but it won't have a big impact on your earning potential. However, if you are a bodybuilder, fitness center membership is directly related to earning potential. If your membership is not paid, your income is also in danger of decreasing. Thus, this expense needs to be taken into account as a deduction from income so that your FCFE is reduced.
Step 2. Understand the role of the analyst
Analysts determine whether reinvestment costs and capital are required to maintain and/or increase company profits. This involves data analysis, and creative thinking.
For example, if a company reduces its purchases of equipment, expenses will decrease in the short run, but in the long run growth will diminish and even disappear. A good analyst will recognize and respond to this well as well. Possibly, by selling their stake in the company
Step 3. Learn the FCFE formula
There are several ways to calculate FCFE directly or indirectly. However, the most direct formula is: = NI + NCC + Int x (1 – Tax rate) – FCInv – WCInv + Net borrowing. These variables will be explained as follows.
- NI: Net Income (Net income). This is the total profit of the company after all income is deducted by all expenses and taxes for a certain accounting period.
- NCC: Non-cash charges (Non-cash charges). These are income-deducting expenses that do not require cash payments in the period to which they relate. For example, depreciation expense in the current period due to manufacturing costs in the previous period.
- Int: Interest income (Interest income). This income is received by the lender of capital. This income includes the interest received from the debtor on the loan. This variable usually refers to a financial company.
- FCInv: Fixed Capital Expenditures. These are purchases by companies that are needed to maintain or improve operations and productivity, for example the purchase of new vessels for a transportation company.
- WCInv: Working Capital Investment (Working Capital Investment). This figure is obtained by subtracting the company's current assets (cash, inventory, and receivables) with its current liabilities (short-term debt and trade payables). This figure will measure the company's ability to pay its maturing expenses and includes the amount of cash and cash equivalents available for reinvestment and growing its business.
- Net Borrowing or Net Loans. This figure is calculated by subtracting the principal amount of the loan paid by the company and the number of loans made in the same period. In other words, Net Loan = Loan Amount – Principal Amount Paid. If the loan taken by the company is more than the payments made, the cash available to be given to shareholders becomes more.
Step 4. Understand when it is appropriate to use FCFE
FCFE is not always the best method of analysis, but you can get an idea of the availability and use of cash if the following are appropriate for the company being examined:
- Company earns profit
- Stable corporate debt
- You focus on valuing the company's equity.
Part 2 of 2: Calculating FCFE
Step 1. Obtain company information
Income statements, cash flow statements, and statements of financial position of public companies should be available from the companies themselves as well as from organizations such as IDX.
- These documents will provide the most vital information for calculating FCFE.
- Other information that can be obtained to provide a more detailed picture of the company's spending patterns will also be useful in making the analysis.
Step 2. Find the company's most recent net income
Usually this figure can be found at the bottom of the income statement.
For example, let's say that ABC's net income is $2,000,000
Step 3. Add non-cash expenses
These costs include depreciation and amortization. These two expenses are usually listed on the income statement. However, it can also be found in the cash flow statement. This expense reduces profit but does not reduce cash.
- These expenses are added because they do not reflect actual cash outlays, and therefore these funds are theoretically still available as equity to shareholders.
- Let's say company ABC has $200,000,000 in non-cash expenses this year
- IDR 2,000,000,000 + IDR 200,000,000 = IDR 2,200,000,000
Step 4. Reduce fixed capital expenditures
You must reduce the expenses that the company needs to continue and increase its productivity (eg new equipment).
- You can estimate the figure using the “capital expenditure” figure on the company's cash flow statement.
- Let's say company ABC has fixed capital expenditures of $400,000.
- IDR 2,200,000,000 - IDR 400,000,000 = IDR 1,800,000,000.
Step 5. Subtract the working capital investment figure
Every company must have funds for its daily operations. This fund is a working capital investment. You can estimate this by using the company's current assets and current liabilities in the most recent statement of financial position.
- Subtract the company's current assets from its current liabilities. The results will show how much money the company has for its daily expenses, both unexpected and unexpected.
- This figure can be a measure of the company's short-term financial health. Companies that do not have positive working capital tend not to last long.
- On the other hand, excessive working capital shows signs of inefficiency, which means that the company does not invest its excess funds to increase profits.
- Let's say company ABC has a working capital investment of $200,000.
- IDR 1,800,000,000 - IDR 200,000,000 = IDR 1,600,000,000.
Step 6. Add net loans
Add additional funds that the company has due to making loans. This is determined by subtracting the amount of debt paid by the number of loans made in the same calculation period.
- To complete the calculation, compare the debt figures on the company's statement of financial position. Subtract the amount owed at the beginning of the period by the number at the end of the period. A positive number means that net borrowing has increased, while a negative number means that net borrowing has decreased.
- Let's say company ABC borrowed $500 million this year.
- IDR 1,600,000,000 + IDR 500,000,000 = IDR 2,100,000,000
- Thus, the company's FCFE is IDR 2.1 billion
Step 7. Analyze your results
The reason for doing this calculation is to remove accounts that do not reflect reality. This result allows you to determine how much cash actually comes in and what actually goes out. Therefore, you can find out the amount of funds that may be given to company investors.
- Skilled analysts can use this information to spot incorrect price pairs, (eg determine whether a company is overvalued or undervalued by investors) and adjust its value accordingly.
- Look for a continuing mismatch between the FCFE and the dividend payout rate. This indicates the availability of additional cash in the hands of the company that the analyst should note. This can be a positive signal, because it means the company has funds/cash to invest, distribute repurchases, increase dividends, or protect against a potential recession.
- On the other hand, if the dividend exceeds the FCFE, the continuity of the dividend may be problematic.
