NISM-Series-XV: Research Analyst · Company Analysis - Financial Analysis

Cash Flow Analysis and Free Cash Flow (FCFF and FCFE)

Updated 11 October 2026 · Fact-checked

Cash flow analysis reads the cash flow statement in three parts: operating, investing and financing. Free cash flow is cash left after reinvestment. FCFF = CFO + Interest × (1 − t) − Capex, and goes to all capital providers. FCFE = CFO − Capex + Net borrowing, and goes to shareholders.

Understand Cash Flow Analysis and Free Cash Flow

A company can report profit and still run out of cash. Profit is an accounting number built on accruals. Cash is what actually moves in and out of the bank. The cash flow statement shows this movement and splits it into three parts.

Cash flow from operations (CFO) is cash generated by the core business: collections from customers less payments to suppliers, staff and taxes. Cash flow from investing (CFI) covers buying and selling long-term assets such as plant, investments and acquisitions. Cash flow from financing (CFF) covers raising and repaying debt, issuing or buying back shares, and paying dividends. Interest and dividend classification can differ by standard, so read the notes.

A healthy mature company shows positive CFO, negative CFI (it is investing) and CFF that depends on its stage. Steady positive CFO that tracks or exceeds net profit signals good quality of earnings. If net profit rises but CFO stays weak for several years, check receivables, inventory and aggressive revenue recognition.

Free cash flow is the cash available after the business has paid for the investment it needs. FCFF (free cash flow to firm) is available to all capital providers, lenders and shareholders, before financing payments. FCFE (free cash flow to equity) is what remains for shareholders after lenders are paid and net borrowing is considered. FCFF is discounted at WACC; FCFE is discounted at the cost of equity.

Key formulas to remember

Cash flow identity: Net change in cash = CFO + CFI + CFF; The three sections add up to the change in cash and equivalents.
FCFF from CFO: FCFF = CFO + Interest × (1 − t) − Capex; Use this when CFO is after interest paid (interest in operating activities). Add back interest after tax.
FCFF from net income: FCFF = NI + Non-cash charges + Interest × (1 − t) − Increase in working capital − Capex; Non-cash charges are mainly depreciation and amortisation.
FCFF from EBIT: FCFF = EBIT × (1 − t) + Depreciation − Increase in working capital − Capex; Starts before interest, so debt does not affect it.
FCFE from FCFF: FCFE = FCFF − Interest × (1 − t) + Net borrowing; Net borrowing = new debt raised − debt repaid.
FCFE from CFO: FCFE = CFO − Capex + Net borrowing; CFO is already after interest, so no interest adjustment.
Cash conversion (quality of earnings): CFO ÷ Net profit; Consistently near or above 1 suggests good quality; persistently well below 1 is a warning.
Discount rates: FCFF → WACC; FCFE → cost of equity; Match the cash flow to the rate.

How to solve Cash Flow Analysis and Free Cash Flow questions

Use this order for any cash flow or free cash flow question.

1Identify what is asked: a section total, cash change, quality ratio, FCFF or FCFE.
2Check where interest is placed. If CFO is after interest, you must add back interest × (1 − t) for FCFF.
3Note whether capex is given as an outflow. Subtract its size; do not subtract twice if it is already a negative number.
4Adjust for working capital: an increase in working capital reduces cash flow; a decrease adds to it.
5Pick the starting point given (CFO, net income or EBIT) and use the matching formula.
6For FCFE, add net borrowing (new debt minus repayments).
7Compute in order, in ₹ crore or the unit given, and check the sign.
8Match the discount rate: WACC for FCFF, cost of equity for FCFE.

Quickest way: Start from CFO and move to FCFE or FCFF

When to use it: Use when the question gives CFO, capex, interest, tax rate and borrowing in numbers.

Write FCFE = CFO − Capex + Net borrowing first.
If asked for FCFF, take CFO − Capex and add Interest × (1 − t).
Check FCFF − FCFE: it equals Interest × (1 − t) − Net borrowing.
Eliminate options with the wrong sign for working capital or capex.
For quality questions, divide CFO by net profit and compare with 1.

Common mistakes in Cash Flow Analysis and Free Cash Flow

Adding interest back without tax adjustment in FCFF.
Students forget interest saves tax.
Fix: Always add Interest × (1 − t), not the full interest, when moving from CFO or net income to FCFF.
Adding back interest to CFO for FCFE.
FCFE is confused with FCFF.
Fix: FCFE belongs to shareholders after interest, so CFO (after interest) needs no add-back.
Treating an increase in working capital as a cash inflow.
Assets going up looks positive.
Fix: More receivables or inventory ties up cash. An increase in working capital reduces free cash flow.
Ignoring net borrowing in FCFE.
Students remember only the FCFF formula.
Fix: Add new debt raised and subtract debt repaid.
Calling high profit proof of good cash generation.
Accrual profit is mistaken for cash.
Fix: Compare CFO with net profit over several years. A persistent gap points to weak earnings quality.
Discounting FCFE at WACC or FCFF at cost of equity.
Both are called free cash flow.
Fix: FCFF goes with WACC; FCFE goes with cost of equity.

Worked examples

Example 1

A company reports CFO of ₹500 crore (after interest paid), capex of ₹200 crore, interest expense of ₹60 crore, tax rate 25%, and net borrowing of ₹40 crore. Find FCFF and FCFE.

Show the solution

After-tax interest = 60 × (1 − 0.25) = ₹45 crore.
FCFF = CFO + Interest × (1 − t) − Capex = 500 + 45 − 200 = ₹345 crore.
FCFE = CFO − Capex + Net borrowing = 500 − 200 + 40 = ₹340 crore.
Check: FCFF − after-tax interest + net borrowing = 345 − 45 + 40 = ₹340 crore.

Answer: FCFF = ₹345 crore; FCFE = ₹340 crore.

Example 2

A firm has EBIT of ₹400 crore, tax rate 30%, depreciation of ₹80 crore, capex of ₹150 crore and an increase in working capital of ₹30 crore. Its net profit is ₹210 crore and CFO is ₹168 crore. Find FCFF and the CFO to net profit ratio.

Show the solution

EBIT × (1 − t) = 400 × 0.70 = ₹280 crore.
Add depreciation: 280 + 80 = ₹360 crore.
Subtract increase in working capital: 360 − 30 = ₹330 crore.
Subtract capex: 330 − 150 = ₹180 crore. This is FCFF.
CFO ÷ Net profit = 168 ÷ 210 = 0.8.

Answer: FCFF = ₹180 crore; CFO to net profit = 0.8, below 1, so check receivables and inventory if this persists.

Exam tips

Questions often give interest, tax rate and borrowing together. Decide first whether the answer is FCFF or FCFE.
Know the direction of each item: depreciation added back, capex and working capital increases subtracted.
Expect conceptual MCQs on quality of earnings: CFO persistently below net profit is a red flag.
Remember the pairing: FCFF with WACC, FCFE with cost of equity.
With negative marking, skip a calculation only if you cannot fix the starting point; most are two or three steps.

Practice questions from Company Analysis - Financial Analysis

Cash Flow Analysis and Free Cash Flow in other exams

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

Cash Flow Analysis and Free Cash Flow: frequently asked questions

What is the difference between FCFF and FCFE?

FCFF is cash available to all capital providers, before interest and debt flows. FCFE is cash available to shareholders after interest and net borrowing. FCFF is discounted at WACC and FCFE at the cost of equity.

How do I analyse a cash flow statement?

Read the three sections separately. Check whether CFO is positive and compares well with net profit. See if investing outflows are funded by CFO or by borrowing. Then review financing for debt and dividend patterns.

Why does CFO to net profit matter?

It shows how much accounting profit turns into cash. A ratio consistently near or above 1 suggests good quality earnings. A ratio persistently well below 1 may mean profits are stuck in receivables or inventory, or are aggressively recognised.

Can free cash flow be negative?

Yes. A growing company with heavy capex may have negative free cash flow even when profitable. This is not always bad, but it must be funded by debt or equity.