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