How Free Cash Flow to Equity Give a Catch to Liquidity Status of a Business

Free Cash Flow to Equity = Net income + depreciation + amortization – Capital expenditures – ∆Working capital + net borrowing

Free Cash Flow to Equity formula is long enough but isuseful to calculate the equity available for shareholders. In the first part offree cash flow to equity ratio net income, depreciation & amortizationvalues are added. While in the second portion we subtract capital expense,change in working capital & net borrowing are then subtracted from the firstpart.

Free cash flow to equity ratio considers all the accountingexpenses which are mandatory for operations of an entity and also necessary forfuture growth for calculation purpose.

The values in the free cash flow to equity formula are readily available from the financial statements of a company. For instance, net income is available at the income statement, however, one can also use the cash flow statement to get the value for net income or income after interest and taxes.

Depreciation charges are available in an income statementwhile the capital expenditure breaks down is available at the cash flowstatement. On the other side, the working capital figure can becalculated by subtracting current assets and current liabilities. We usecurrent assets and current liabilities due to the fact that these items areliquid in nature and generally for a period of less than one year. One can usea balance sheet to find current assets & current liabilities.

Moreover, net borrowing refers to the difference in openingand closing balance of the company’s debt. Means during the period what the companyrepays and what is left behind or what is newly added and what is the finalfigure. On the other side net borrowing, the difference can also be found bycomparing the changes in the balance sheet. (* Do not reconsider interestfigure here, as it is already added before).

How free cash flow to equity formula is useful for investors

Free cash flow to equity can be helpful in multiple aspectsessentially when evaluating shares of a company from an investment point ofview. Free cash flow to equity ratio can be used as a replacement of dividendsalong with retained earnings ratio to determine the possible dividendpayout ratio for the coming year.

In addition to the above free cash flow to equity, the modelis useful for stock valuation purpose. Although dividend discountapproach is also another way to calculate stock valuation however, free cashflow to equity differs and do not consider dividends for valuation.

To understand the approach free cash flow to equity uses forstock valuation let’s take a look on the components of the formula and thencompare with the dividend discount model. The first part takes the netincome of the company or you can say net earnings then it subtracts the capitalexpenditures to consider the amount required for normal operations and growth. Everycompany pays some of the amounts to the shareholders in the form of dividendsand remaining is kept for future growth as retained earnings.

At next, free cash flow to equity formula considers forchange in working capital, to take in to account the future needs for shortterm operations. At last net borrowing is added or subtracted (if negativebalance) for adding it in final shareholder’s equity figure as a new capitalinjection or subtraction due to payback.

As we said earlier, free cash flow to equity only calculatesthe amount available to shareholder this does not necessarily mean that it willbe the dividends payout to shareholders. For that, a number of othertechniques can be used including retained earnings ratio, dividend payout ratioanalysis, along with multiple others to forecast the dividend.