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Know what free cash flow is and how to calculate it to understand a company’s financial health and its efficiency to generate cash

Free cash flow: What this metric tells you about a company’s financial health

Stock market investors pore over the financial statements and analyst reports of listed companies to get updated on a company’s net income, price-to-earnings ratio and free cash flow.

But some investors may not fully grasp the concept of free cash flow. How does it differ from net income and regular cash flow and, more importantly, how can you use it to better analyse a company’s financial health?

 

What is free cash flow and how do you calculate it?

Free cash flow is the cash a company is left with after deducting all its cash payments towards capital expenditure (e.g. property and equipment), inventory, debt and other operating expenses. It measures how efficient a company is at generating cash.

There are several ways of calculating free cash flow, but the easiest method is to:

  1. Find the Cash Flows from Operations figure on a company’s cash flow statement
  2. Find the company’s total capital expenditure in the Cash Flows from Investing section
  3. Subtract the second figure from the first to derive the company’s free cash flow

3 things free cash flow can tell you

  1. Ability to repay debt and take on future borrowings: Subtracting a company’s debt payments from its free cash flow figure will indicate its ability to repay its current debt and its ability to borrow in the future.
  2. Ability to pay out dividends: The figure after deducting debt and interest payments from free cash flow indicates the company’s ability to pay out current and future dividends.
  3. Change in fundamental business trends: When analysing a company’s free cash flow figures, pay attention to both the static figure as well as the trend (how it changes from year to year). The free cash flow trend tends to be jagged instead of smooth. The changes from year to year can tell you a lot about a company’s fundamental business operations.

For instance, a large dip in free cash flow may be a result of heavy capital expenditure for business growth. However, a drop in free cash flow could also indicate that the company is having trouble offloading inventory, is extending payment terms to its customers or that its suppliers are tightening payment terms (indicating potential credit issues).

All investors should learn to analyse a company’s financial health so that they can make better and smarter investment decisions. Free cash flow is one metric that can equip you for this.

Points to ponder

  1. How does free cash flow differ from net income?

Many items in a company’s total net income may not actually generate any cash for the company.

For instance, items sold on credit can be booked as income at the time of sale, even if they have not yet been paid for. Non-cash items such as depreciation and amortisation expense may also distort a company’s true financial standing.

Finally, because the market focuses so much on net income figures, companies may be motivated to paint a rosier picture. For instance, a company may extend overly generous payment terms to its customers in order to boost its net income for the period.

  1. What’s the difference between free cash flow and regular cash flow?

The main difference is that free cash flow takes into account capital expenditure. A positive cash flow does not necessarily mean a company is in good financial health as this can be generated by a company taking on additional debt or selling-off long-term assets at the expense of future growth. Hence, free cash flow provides a truer picture of a company’s actual cash flow position.

Want to understand this better? Standard Chartered Bank is committed to helping you succeed in your investment journey. Speak to one of our financial advisers today to learn more about how we can help you.

This article is brought to you by Standard Chartered Bank (Singapore) Limited. All information provided is for informational purposes only

Disclaimer:

This article is for general information only and it does not constitute an offer, recommendation or solicitation to enter into any transaction. This article has not been prepared for any particular person or class of persons and it has been prepared without regard to the specific investment or insurance objectives, financial situation or particular needs of any person. You should seek advice from a licensed or an exempt financial adviser on the suitability of a product for you, taking into account these factors before making a commitment to purchase any product. In the event that you choose not to seek advice from a licensed or an exempt financial adviser, you should carefully consider whether the product is suitable for you. You are fully responsible for your investment decision, including whether the investment is suitable for you. The products/services involved are not principal-protected and you may lose all or part of your original investment amount.