Free cash flow can be very useful measure to understand the true profitability of a company. It is hard to manipulate and is a more conservative approach than most commonly used metric such as net profit. In this post we are going to discuss:
- What is Free Cash Flow?
- Why you should use Free Cash Flow?
- How to calculate Free Cash Flow?
- Interpretation of Free Cash Flow
What is Free Cash Flow?
Imagine a small candy shop, selling candies to little kids. The shop owner keeps a jar where he puts all his profits from sale of candies. Now, whenever he needs money for his business purpose such as, repairing his shop, buying a new candy machine, etc, he takes out the money from that jar and spends it for his business growth. Whatever is left in the jar, is what he can take home or use to pay his debts.
The cash profit earned from sale of candies is the operating cash flow, the money used in buying candy machine is capital expenditure and the cash left in the jar is free cash flow.
Free cash flow is the total cash generated by a company that is available to the investors, after accounting for all the capital expenditure such as purchase of building, plant, machinery etc. In other words, free cash flow is the real earning of the company that can be deposited in its bank account immediately.
Free cash flow is important from an investor’s point of view, as it allows company to enhance shareholders value. Free cash flow can be used in business expansion, dividend payment, debt payment or other purposes.
As the Free cash flow increases, the strength of balance sheet improves, an important indicator of company’s financial well being.
Also Read: Most Important Balance Sheet Terms Explained
Why you should use Free Cash Flow?
While earning is a measure of profitability of a company, free cash flow is the real measure of the cash position of a company, which can be used for various purposes such as acquisition of assets, paying dividends, reducing debts etc.
Free cash flow shows the ease with which a company can grow its business without the need of external funding and create more wealth for shareholders.
Further, Free cash flow is widely used as an important input in company valuation such as Discounted Cash Flow (DCF) method. DCF is the most widely used valuation model used by large institutions while valuing a company.
How to calculate Free Cash Flow?
There are two methods for calculating Free cash flow first, by subtracting changes in working capital and capital expenditure from company’s EBITDA (Earning Before Interest Taxes Depreciation and Amortization). The Formula for calculating Free cash flow using this method is as follows:
EBITDA(1-taxes)-(Changes in working Capital)-(Capital expenditures)
If the method above looks a bit complicated, don’t worry, there is another, more easier method of calculating free cash flow using the cash flow statement. For this you need operating cash flow and capital expenditures. The formula for the same is as follows:
FCF= Cash Flows from operating activities- Capital Expenditure
Interpretation of Free Cash Flows:
The most important aspect of studying cash flows is to understand the source from where the cash is coming. There are mainly two sources from where the cash can come in, first from earnings of a company, second from raising debt. While cash flow from earnings is good, cash from debt is always a bad sign as it creates more liabilities for the companies to be paid in the future.
Secondly, if a company has high capital expenditure, it demands a proper investigation whether the expenditure is used to create assets or is it an expenditure. Capital expenditure in asset creation allows companies to generate higher revenue in the future, while latter signifies poor financial health of the company.
To understand where the money is going, you need to go through the company’s annual report.
A consistently declining or negative free cash flow is a warning sign. Negative Free cash flow indicates slowdown in the cash generating ability of the business, which may lead to insufficient liquidity to keep the business running.
Free Cash flow is one of the most reliable and widely used metric among value investors, as it provides accurate position of the company’s financial condition.
In simple words, free cash flow is an account of how much cash a company is left with after paying for all expenses.
Companies that manage to generate consistently large cash flows without incurring much capital expenditure are always valued higher by investors. Negative free cash flows are sign of deteriorating health of a company.