Free Cash Flow

The cash left after making investments towards capital

What is a free cash flow?

Free cash flow measures a company’s financial performance. It also shows the cash that the company can produce after it has purchased assets such as infrastructures, equipment, and other major investments. In other words, free cash flow also determines a company’s financial health and long-term profitability.

 

What is the importance of the free cash flow?

Knowing the company’s free cash flow enables management to decide on future ventures that would improve the shareholder value. Additionally, having an abundant free cash flow indicates that a company is capable of paying their monthly dues. Companies can also use their free cash flow to expand business operations or pursue other short-term investments.

Compared to earnings per se, free cash flow is more transparent in showing the company’s potential to produce cash and profits.

Meanwhile, other entities looking to invest may likely consider companies that have a healthy free cash flow because of a promising future. Couple this with a low-valued share price, investors can generally make good investments with companies that have high free cash flow. Other investors greatly consider free cash flow compared to other measures because it also serves as an important basis for stock pricing.

 

free cash flow example

 

How is the free cash flow calculated?

There are various ways to compute for free cash flow, although they should all give the same results. The formula below is a simple and commonly used formula for levered free cash flow:

Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures

 

Most information needed to compute a company’s free cash flow is on the cash flow statement. As an example, let Company A have $22 million dollars of cash from its business operations and $6.5 million dollars used for capital expenditures, net of changes in working capital. Company A’s free cash flow is then computed as:

FCF = $22 – $6.5 = $15.5m

 

What are some limitations associated with the free cash flow?

The company’s net income greatly affects a company’s free cash flow because it also influences a company’s ability to generate cash from operations. As such, other activities (i.e. those not within the core business operations of a company) from which the company generates income must be scrutinized deeply in order to reflect a more appropriate free cash flow value.

On the investors’ side, they must be wary of a company’s policies that affect their declaration of free cash flow. For example, some companies lengthen the time to settle their debts to maintain cash or, the opposite; shortening the time they collect debts due to them. Companies also have different guidelines on which assets they declare as capital expenditures, thus affecting the computation of free cash flow.

 

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