When it comes to financial analysis, there are two metrics that internal stakeholders and external users, such as investors and analysts, can use to assist with analyzing a business’s operations.
Free cash flow to the firm (FCFF) is used as part of a discount cash flow (DCF) calculation that aids in determining a company’s intrinsic value, helping investors make better informed decisions. This metric provides insight into how much cash flow is available to all funding claimants of the business (be it convertible bond investors, debt holders, and preferred and common stockholders). This is compared to free cash flow to equity (FCFE), which is how much cash flow a business can use if it has zero debt.
While there are many ways to arrive at FCFF, the following is one way to calculate it:
Step 1
Start with Net Operating Profit (NOPAT), which is determined by Earnings Before Interest and Taxes x (1 – Tax Rate)
Step 2
Add Depreciation and Amortization expenses to NOPAT
Step 3
Remove Capital Expenditures
Step 4
Remove Modifications in Net Working Capital
Further Considerations of FCFF Versus FCFE
FCFF assumes there are no payments for interest; nor have any changes in debt been factored in the company’s financial statements. FCFE factors in interest payments and any applicable changes in debt the company may have taken or paid off during the particular accounting time frame. FCFE provides analysts with the ability to determine how efficient a company is and how well (or not) it is at producing cash for equity holders.
Defining NOPAT
NOPAT is a way to see what the company’s operations produce, assuming it has no debt and, accordingly, no outstanding interest expense obligations. It gives analysts and investors an opportunity to look at potential investments with a standardized metric because companies can be seen as having debt and not having debt. It provides easier ability to see if companies can obtain and/or manage debt levels, along with other financial metrics used by investors and analysts.
Along with the already established formula to calculate NOPAT, there’s an alternate formula:
(Net Income + Tax + Interest Expense + Any Non-Operating Gains/Losses] x (1 – Tax Rate)
Operating Earnings = the company’s profits pre interest and taxes (or what the company would earn if it had zero debt, and therefore zero interest expense).
Putting NOPAT in Context
Other important considerations for NOPAT are that it excludes changes in accounts receivable, inventory, accounts payable, and inventory. Additionally, it excludes capital expenditures but accounts for amortization and depreciation.
How NOPAT Assists Analysts and Investors
Businesses can use this data to see how this metric drills down on the business’s core functions. It’s a way to determine how profitable or not a business’ core functions are over shorter and longer time frames. It helps businesses determine how efficient a company is against its competitors since it removes debt and tax comparisons.
Analysis is easier for both businesses looking for acquisitions and for investors. NOPAT helps investors determine which companies are most efficient within their sector based on their main functions. It helps remove the “noise” of debt levels and tax situations.
Looking at these two metrics at face value can seem daunting, but after breaking them down and understanding the differences, it’s easier to see how they aid in financial analysis.
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