CFA Level I Exam · Analyzing Statements of Cash Flows I

FCFF, FCFE and Cash Flow Ratios for CFA Level I

Updated 7 October 2026 · Fact-checked

FCFF is cash available to all capital providers; FCFE is cash available to shareholders only. From CFO: FCFF = CFO + interest × (1 − tax rate) − fixed capital investment, and FCFE = CFO − fixed capital investment + net borrowing. Cash flow ratios divide CFO by revenue, assets, debt, interest or dividends to test earnings quality and liquidity.

Understand Free Cash Flow and Cash Flow Analysis Ratios

Free cash flow is the cash a company generates after paying for the investment needed to sustain and grow its operations. Net income is built on accruals. Cash flow from operations (CFO) is closer to real cash. Free cash flow goes one step further and subtracts spending on fixed assets.

Free cash flow to the firm (FCFF) is the cash available to all providers of capital, both debtholders and shareholders, after operating costs, taxes, working capital and capital spending. Interest is a payment to a capital provider, so it is not deducted. Starting from CFO under US GAAP, interest paid has already reduced CFO, so you add it back after tax: interest × (1 − tax rate). It is added after tax because interest saves tax. Under IFRS, a company may report interest paid in financing instead. In that case CFO is already before interest and you do not add it back. Read the question for where interest sits.

Free cash flow to equity (FCFE) is the cash available to shareholders after all payments to debtholders. Start from CFO, subtract fixed capital investment, and add net borrowing (new debt issued minus debt repaid). If interest paid is already in CFO (always under US GAAP, or under IFRS if the company classifies it that way), you make no interest adjustment. If an IFRS company reports interest paid in financing, CFO is before interest, so subtract interest (after the tax effect, as the question gives it) from CFO first.

Cash flow ratios come in two groups. Performance ratios (CFO to revenue, to assets, to equity, to operating income, and per share) show how well profit turns into cash. A cash-to-income ratio far below 1 over several years is a warning on earnings quality. Coverage ratios (debt coverage, interest coverage, reinvestment, debt payment, dividend payment, investing and financing) show whether CFO can meet obligations and fund growth. Common-size cash flow analysis scales each line to revenue, or to total inflows and outflows, so you can compare years and companies of different size.

Key formulas to remember

FCFF from CFO: FCFF = CFO + Int × (1 − t) − FCInv; Use when interest paid is inside CFO (always under US GAAP; a choice under IFRS). FCInv is fixed capital investment, net of asset sale proceeds if given.
FCFF from net income: FCFF = NI + NCC + Int × (1 − t) − FCInv − WCInv; NCC is non-cash charges such as depreciation. WCInv is the increase in net operating working capital. A decrease adds to FCFF.
FCFE from CFO: FCFE = CFO − FCInv + Net borrowing; Net borrowing = debt issued − debt repaid. No interest adjustment is needed when interest paid is in CFO. If IFRS interest paid is in financing, subtract it (after tax effect as given) from CFO first.
FCFE from FCFF: FCFE = FCFF − Int × (1 − t) + Net borrowing; Reverses the interest add-back and adds net borrowing.
Performance ratios: CFO ÷ revenue; CFO ÷ average total assets; CFO ÷ average equity; CFO ÷ operating income; (CFO − preferred dividends) ÷ weighted average ordinary shares; The ratios are cash flow to revenue, cash return on assets, cash return on equity, cash to income, and cash flow per share. Higher and stable is better.
Coverage ratios: Debt coverage = CFO ÷ total debt; Interest coverage = (CFO + interest paid + taxes paid) ÷ interest paid; Reinvestment = CFO ÷ cash paid for long-term assets; Debt payment = CFO ÷ cash paid for long-term debt repayment; Dividend payment = CFO ÷ dividends paid; Investing and financing = CFO ÷ cash outflows for investing and financing; Above 1 means CFO alone covers the item. Interest and taxes are added back because CFO is after both.
Common-size cash flow: Each line ÷ revenue, or each line ÷ total cash inflows (or outflows); Use the same base for all periods. The revenue method is common for operating cash flows.

How to solve Free Cash Flow and Cash Flow Analysis Ratios questions

Use this order for any FCFF, FCFE or cash flow ratio question.

1Identify what is asked: FCFF, FCFE, a performance ratio, a coverage ratio or a common-size figure.
2Find your starting point: CFO, net income or EBIT. Pick the formula that begins with the data you are given.
3Check where interest paid is reported and which standard applies. If interest is already in CFO, add back interest × (1 − t). If CFO is before interest, do not.
4Pull each input with its sign: depreciation is added back, a working capital increase is subtracted, capex is subtracted, net borrowing is added.
5Compute net borrowing as debt issued minus debt repaid. Do not use interest expense or dividends here.
6For ratios, use the right denominator: averages for asset and equity ratios, year-end totals where the formula says total debt, and cash paid for coverage items.
7Cross-check the link between the two measures: FCFF − FCFE = Int × (1 − t) − net borrowing. Use it to verify your own FCFF and FCFE figures when you compute both, not to eliminate options.
8Interpret if asked: weak CFO relative to income points to low earnings quality, and coverage below 1 means external funding is needed.

Quickest way: Start from CFO and adjust only for what is missing

When to use it: Use when the question gives CFO or a cash flow statement. It avoids rebuilding cash flow from net income.

For FCFF: take CFO, add after-tax interest, subtract capex.
For FCFE: take CFO, subtract capex, add debt issued, subtract debt repaid.
Do the arithmetic once and compare it with the three options. Numerical options run from smallest to largest, so the traps often sit at both ends.
Typical traps are the wrong sign on net borrowing, pre-tax interest, or a forgotten tax adjustment. Compute each trap value mentally and rule it out.
On the BA II Plus, key it as a chain: 500 − 200 + 90 = 390, and do not store partial results.

Common mistakes in Free Cash Flow and Cash Flow Analysis Ratios

Adding back pre-tax interest in FCFF.
Candidates remember that interest is added back and forget the tax shield.
Fix: Always write Int × (1 − t). Interest expense reduced taxes, so only the after-tax amount was a cost in CFO.
Subtracting net borrowing in FCFE, or using only debt issued.
Repayments look like outflows and issuance looks like an inflow, so candidates mix up the direction.
Fix: Net borrowing = issued − repaid, then add it. Borrowing gives shareholders access to more cash. Repayment reduces FCFE.
Adjusting CFO for interest when FCFE is asked, without checking where interest paid sits.
Candidates copy the FCFF structure, or assume CFO is always after interest.
Fix: No interest adjustment is needed when interest paid is in CFO (US GAAP, or IFRS if so classified). If IFRS reports interest paid in financing, subtract it (after the tax effect, as given) from CFO first.
Treating a working capital increase as a source of cash.
The word increase feels positive.
Fix: A rise in receivables or inventory uses cash and is subtracted. A rise in payables, or a fall in net working capital, adds to cash.
Using the wrong denominator in cash flow ratios.
Many ratios look alike.
Fix: Cash return on assets and equity use averages. Interest coverage adds back both interest and taxes paid to CFO. Dividend payment uses dividends paid, not declared.
Ignoring the IFRS classification choice for interest and dividends.
Candidates learn only the US GAAP layout.
Fix: Under IFRS, interest and dividends received can be in CFO or CFI, and interest and dividends paid in CFO or CFF. Check the statement and adjust only if interest sits in CFO.

Worked examples

Example 1

A company reports net income of €400 million, depreciation of €120 million, interest expense of €50 million, a tax rate of 30%, an increase in net working capital of €40 million, and capital expenditure of €150 million. What is FCFF? A) €330 million B) €365 million C) €380 million

Show the solution

Use FCFF = NI + NCC + Int × (1 − t) − FCInv − WCInv.
After-tax interest = 50 × (1 − 0.30) = 35.
Add: 400 + 120 + 35 = 555.
Subtract capex and the working capital increase: 555 − 150 − 40 = 365.
Check traps: omitting the interest add-back gives 330, and adding pre-tax interest gives 380.

Answer: B) €365 million

Example 2

A company reports CFO of $500 million and capital expenditure of $200 million. During the year it issued $150 million of new debt and repaid $60 million. What is FCFE? A) $210 million B) $300 million C) $390 million

Show the solution

Use FCFE = CFO − FCInv + Net borrowing.
Net borrowing = 150 − 60 = 90.
FCFE = 500 − 200 + 90 = 390.
Check traps: ignoring borrowing gives 300, and subtracting net borrowing gives 210.

Answer: C) $390 million

Exam tips

Most questions are one-step substitutions into FCFF or FCFE. Identify the starting point (CFO or net income) before you touch the numbers.
Watch for the words US GAAP or IFRS. They tell you where interest paid sits and whether an add-back is needed.
Distractor options usually come from the standard errors: pre-tax interest, wrong sign on net borrowing, or a missing tax adjustment. Compute those values to see which option is which.
For ratio interpretation, remember that CFO well below net income across several periods points to weaker earnings quality, and coverage ratios below 1 suggest dependence on external financing.
With about 90 seconds per question, do not rebuild a statement. Use CFO-based formulas whenever CFO is given.

Practice questions from Analyzing Statements of Cash Flows I

Free Cash Flow and Cash Flow Analysis Ratios in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Free Cash Flow and Cash Flow Analysis Ratios: frequently asked questions

What is the FCFF formula from CFO?

FCFF = CFO + interest × (1 − tax rate) − fixed capital investment. Use it when interest paid is reported inside CFO, as under US GAAP. If interest paid is classified as financing under IFRS, CFO is already before interest and you skip the add-back.

How do I calculate FCFF from net income?

FCFF = net income + non-cash charges + interest × (1 − tax rate) − fixed capital investment − increase in working capital. Add depreciation, add after-tax interest, then subtract capex and the working capital increase.

What is the difference between FCFF and FCFE?

FCFF is cash available to both debtholders and shareholders. FCFE is cash left for shareholders after interest and net borrowing. FCFE = FCFF − Int × (1 − t) + net borrowing.

Which cash flow ratios should I know for the CFA Level I exam?

Know the performance ratios (CFO to revenue, assets, equity, operating income, and per share) and the coverage ratios (debt, interest, reinvestment, debt payment, dividend payment, investing and financing). Each divides CFO, sometimes adjusted, by a relevant base. Learn which adjustments apply, especially for interest coverage.

How does common-size analysis apply to the cash flow statement?

You scale each line to revenue, or to total cash inflows or outflows. This shows what share of cash comes from operations versus financing and lets you compare periods or companies of different size.