Free cash flow (FCF) as a proxy for management performance
I was visiting with my good friend Tom the banker the other day when the topic suddenly turned to managerial (leadership) effectiveness.
I asked Tom what the best indicator and predictor of managerial effectiveness was. Tom replied with "Free Cash Flow ("FCF") for short.
I remembered this concept to be true from my operational days. I recalled that free cash flow was generally what was available to various stakeholders for distribution.
I'm going to be very careful here not to lose you so please stay with me.
Recall that free cash flow can be calculated in various ways, depending on audience and available data. A common measure is to take the earnings before interest or taxes or EBIT multiplied by (1-tax rate) multiplied by (1 − tax rate); add back depreciation and amortization expense, and then subtract out changes in working capital (your Current Assets-Current Liabilities) and your capital expenditures (see the below table for sources of the components of the equation) Depending on the target audience for a FCF conversation, a number of refinements and adjustments may also be made to try to eliminate undesirable distortions.
Free Cash Flow or FCF Equation: (EBIT * (1-marginal tax rate)) + (Depreciation/amortization)- (Changes in Working Capital)- (Capital Expenditures or "CAPEX")
So, for example (for illustration only; your numbers will certainly vary)
Marginal tax rate=35%
Changes in working capital:$400,000
FCF=$500,000 * (1-0.35) + $600,000-$400,000-$250,000
EBIT Current Income Statement
Tax rate Current Income Statement
Depr/amort Current Income Statement
Changes in working capital Balance sheet (specifically, Current Assets and Current Liabilities)
CAPEX Balance sheet (specifically, Property, Plant and Equipment)
In closing is FCF the only metric that a banker uses for managerial effectiveness? Of course not! There are other qualitative measures.
And, unless you continue to bootstrap your business (EDITORS NOTE: you don't use other people's money or "OPM" to grow your business) FCF is a VERY important metric to various stakeholders in your business including but not limited to equity, debt, preferred stock and convertible.
So, from here, what should I do?
Well, for me, it starts with the calculation and the trend line going forward. In other words, is your FCF position strengthening or weakening over time? A relatively easy calculation for your accountant, CPA or bookkeeper. I would encourage you to get started.