Free cash flow to equity is the amount of cash that a firm has to pay its stockholders dividends. It can be thought of as the amount that is left over after debts, capital expenses and fluctuations in working capital. The free cash flow to equity model does consider both net income and income from new financing. Working capital is calculated as the firm's current assets minus its current liabilities.
Most firms are not required to pay their stockholders dividends. These are income payments that are generated while the stockholder holds shares in the company. A firm either has the choice to use its excess free cash flow to pay out dividends or reinvest that cash in the company as retained earnings. Some firms do choose to pay out periodic dividend payments to discourage the sale of their stock.
The free cash flow to equity model helps firms determine whether they are able to make dividend payments to their stockholders. It first takes into account the company's cash inflow, which includes net income and new loan proceeds. Net income is the amount of the company's sales revenue minus the costs associated with bringing its goods and services to market. Loan proceeds are any cash amounts received from borrowing activities that help maintain a firm's liquidity needs.
Besides a firm's cash inflow, the free cash flow to equity model also takes into account a firm's outflow. Capital expenses are deducted from the amount of inflow. These types of expenses might include the purchase of new equipment or buildings for a new location.
Fluctuations in a company's working capital are typically treated as an outflow. The change in a company's working capital could be either a positive or negative figure. For example, if a firm's working capital for the previous accounting period was $500 US Dollars (USD) and the current period's working capital is $700 USD, the change would be a positive $200 USD. If those numbers were reversed, the change would be a negative $200 USD.
Other outflows that are included in the free cash flow to equity model include payments for debts and loans. Debts might include a number of expenses, including bond payments and IOU's. Loan payments would include any monthly amortization payments or principal balance payoffs.
The model indicates a firm's current free cash flow and accounts for outflows and inflows during a specified time period. For instance, it may be calculated on an annual, quarterly, and monthly basis. Some investors use the free cash flow to equity calculation to assess a company's value and financial stability.