Why do you add net borrowing to FCF to equity?

Free cash flow to equity (FCFE) is an essential financial metric that provides insight into the amount of cash a company has available to return to its equity shareholders after it has met all operational, reinvestment, and financing needs. In other words, it represents the cash that remains after a business has paid for day-to-day expenses, reinvested in capital assets like equipment or property (capital expenditures), adjusted for changes in working capital, and covered any debt payments, either through new borrowing or by repaying existing debt. By focusing on cash flow rather than accounting profits, FCFE provides a clearer picture of the actual liquidity available to shareholders.

The calculation of FCFE begins with net income, which is the company’s earnings after taxes and interest. To this, non-cash expenses, primarily depreciation and amortization, are added back since they are deducted as expenses on the income statement but do not involve actual cash outflows. Capital expenditures, on the other hand, represent the cash required to maintain or expand the company’s physical assets, and they are subtracted from net income because these outlays are essential to sustaining the business. Changes in working capital, which reflect cash tied up in day-to-day operations (like accounts receivable, inventory, and accounts payable), are also adjusted, as increases in working capital require cash, while decreases release cash back into the business.

Another critical component in calculating FCFE is net borrowing, which captures the impact of any new debt issued or debt repaid during the period. Net borrowing reflects the company’s financing decisions and directly affects the cash available to shareholders. If a company borrows more than it repays in a given period, it adds to FCFE, effectively increasing the cash that could be returned to shareholders. Conversely, if the company repays more debt than it borrows, it reduces FCFE, as cash is being diverted to debt repayment rather than being available to equity holders.

FCFE is an important metric because it provides a direct indication of the company’s capacity to generate cash for shareholders after accounting for all necessary investments and financial obligations. For investors, FCFE is highly valuable in determining a company’s potential to pay dividends or buy back shares, as it represents the actual cash flow that could be returned to them. Unlike net income or earnings per share, which can be affected by non-cash accounting adjustments, FCFE focuses specifically on cash flow, making it a more transparent measure of financial health and a more accurate indicator of the company’s value to equity investors.

In valuation, FCFE is often used in the discounted cash flow (DCF) model to estimate the intrinsic value of a company’s equity. By forecasting FCFE over a certain period and discounting it to present value, investors can assess what they should pay for a share of the company today based on its future cash-generating potential. This approach, known as the FCFE valuation model, is particularly useful for companies with stable cash flows and predictable reinvestment needs, as it gives investors a clear sense of how much cash flow they can realistically expect.

For example, if a company consistently generates high FCFE, it indicates that it has sufficient cash to cover all operational, reinvestment, and financing needs, with ample funds left over for equity holders. This can be attractive to investors looking for income through dividends or capital appreciation from share buybacks, as high FCFE suggests the company has the financial strength to support these shareholder returns. Conversely, if a company’s FCFE is low or negative, it may signal that it is reinvesting heavily in its growth, is highly leveraged with debt obligations, or is experiencing operational inefficiencies, which can make it less attractive for income-focused investors.

FCFE also serves as a useful benchmark in assessing financial decisions within the company. For instance, a company with consistently high FCFE may choose to reinvest that cash into growth opportunities, reward shareholders through dividends or buybacks, or reduce its debt to improve financial stability. By providing a realistic measure of available cash, FCFE helps management and investors make informed decisions about how best to allocate resources to maximize shareholder value.

When calculating FCFE, net borrowing is added because it captures the impact of financing activities—specifically, the net effect of new borrowings and debt repayments—on the cash flow that is ultimately available to shareholders. This adjustment provides a more accurate and complete picture of the company’s financial position from an equity holder’s perspective.

When a company borrows additional funds, this inflow increases liquidity without requiring an immediate cash outflow to repay the debt. Essentially, net borrowing reflects extra cash on hand that can be used to finance operations, expand the business, or distribute returns to shareholders. For example, if a company takes out a new loan, the borrowed amount becomes available as additional capital, which the company can use to fund investments or to enhance shareholder value through dividends or stock buybacks. Including net borrowing in FCFE thus reflects these financing activities and shows that the company has greater flexibility to allocate cash toward equity returns.

On the flip side, if a company repays more debt than it borrows, the net borrowing figure becomes negative, reducing FCFE. This outcome signals to shareholders that more cash is being used to reduce the company’s leverage rather than to support shareholder returns. A negative net borrowing figure indicates that debt repayments are consuming cash that would otherwise be available to shareholders. By accounting for net borrowing, FCFE adjusts to show the true cash flow impact of debt management activities, providing investors with a more accurate reflection of what cash is actually available to them.

Moreover, by adding net borrowing to FCFE, analysts can better gauge a company’s financial strategy and risk profile. For instance, companies that consistently rely on borrowing to boost FCFE may be taking on higher financial risk, as they are adding debt obligations that must eventually be repaid. This approach can enhance short-term cash flow available to shareholders, but it may indicate a long-term strategy of increasing leverage, which has implications for the company’s financial health and stability. Conversely, companies with low or negative net borrowing may signal a more conservative approach, focusing on reducing debt rather than increasing short-term cash availability for shareholders.

In essence, adding net borrowing to FCFE is about capturing the impact of financing decisions on equity value. It tells equity holders not only what cash is left after all operating expenses and investments but also how much cash is affected by the company’s financing activities. This comprehensive view is essential for assessing the company’s capacity to provide returns to shareholders and understanding how debt decisions influence the available cash flow.