What is free cash flow (FCF)?
Companies produce free cash flow (FCF) after accounting for cash withdrawals for operations and capital asset maintenance. Unlike profits or net income, free cash flow measures profitability by excluding non-cash costs from the income statement and including spending on equipment, assets, and working capital changes from the balance sheet.
Free cash flow often excludes interest payments.
Investment bankers and analysts utilize free cash flow variations, such as firm and equity free cash flow, to assess a company’s performance with various capital structures, adjusting for interest payments and borrowings.
Free Cash Flow Understanding
Free cash flow is the company’s ability to pay creditors or investors dividends and interest.
Investors may favor FCF or FCF per share over profits or EPS as a profitability indicator due to removing non-cash items from the income statement.
FCF, which includes investments in property, plant, and equipment (PP&E), can be lumpy and uneven across time, making it less valuable for analysis.
Benefits of Free Cash Flow
FCF, which accounts for changes in working capital, can reveal a company’s worth and underlying patterns.
Reduced accounts payable outflow may indicate demands for speedier payment from vendors. Reduced accounts receivable inflow may display faster cash collection from clients. Inventory outflow may imply a growing backlog of unsold goods. Working capital adds insight into profitability that the income statement lacks.
Consider a corporation with $50,000,000 in net profits over the past decade. That appears stable. What if FCF dropped over the previous two years as inventory rose (outflow), consumers delayed payments (inflow), and vendors demanded faster payments? FCF would show a significant financial problem that the revenue statement would not.
FCF analysis aids potential investors and lenders assess the company’s ability to pay dividends or interest. By subtracting debt payments from free cash flow to the firm (FCFF), a lender can better assess cash flows for debt repayment. FCF minus interest payments can indicate dividend stability for shareholders.
The evaluation of free cash flow per share is used to assess dilution, comparable to sales and earnings.
Free Cash Flow Limits
Assume a corporation generates $1,000,000 in EBITDA annually. Assume this corporation acquired $800,000 in new equipment at the end of the year but had no working capital adjustments. Depreciation on the income statement will level out the impact of new equipment expenses on earnings over time.
However, the corporation will report $200,000 in FCF ($1,000,000 in EBITDA minus $800,000 in equipment) on $1,000,000 in EBITDA that year since FCF includes new equipment purchases. Supposing no new equipment acquisitions, EBITDA and FCF will be equal again next year.
An investor must analyze why FCF dropped so fast in one year only to rebound to previous levels and if that trend will persist.
Furthermore, knowing the depreciation technique will provide further information. Net income and FCF may vary depending on the annual depreciation of an asset during its useful life. To fully depreciate an investment over ten years, net income will be $80,000 lower than FCF per year ($800,000 / 10 years).
If the asset is depreciated via tax depreciation, it will be fully depreciated in the year it was acquired, resulting in net income equaling FCF in the following years.
Free Cash Flow Calculation
To calculate FCF, start with cash flows from operational operations on the statement of cash flows, which already accounts for non-cash costs and working capital movements.
The income statement and balance sheet can compute FCF.
Use other income statement, balance sheet, and statement of cash flow elements to calculate. Without EBIT, an investor may calculate the proper amount as follows.
FCF is a helpful tool but does not need financial disclosure like other financial statement line items. Adjusting for CapEx might confuse FCF, but it is an excellent way to verify a company’s declared profitability.
Although the effort is worthwhile, not all investors have the knowledge or time to compute the figure manually. Fortunately, software simplifies calculations.
Define Good Free Cash Flow
Fortunately, most financial websites summarize or graph FCF for most public corporations.
The question remains: What is excellent free cash flow? Many firms with strong free cash flow have poor stock trends, and vice versa.
An FCF trend helps simplify your analysis.
Technical analysts emphasize the importance of focusing on the pattern of fundamental performance over time rather than the absolute quantities of FCF, profits, or revenue. Generally, good FCF movements should correspond with positive stock price trends, as stock prices result from underlying fundamentals.
FCF trend stability is a frequent risk indicator. Stable FCF developments over the past 4-5 years indicate less disruption of favorable market movements. Falling FCF patterns, especially those that deviate from profits and sales trends, suggest a more significant chance of future price decline.
This method overlooks FCF’s absolute value to focus on its slope and price performance.
Examples of Free Cash Flow
Take this example:
| Model of a Hypothetical Company’s Free Cash Flow | ||||||
|---|---|---|---|---|---|---|
| Factor | 2017 | 2018 | 2019 | 2020 | 2021 | TTM |
| Sales/Revenue | $100 | $105 | $120 | $126 | $128 | $130 |
| EPS | $1.00 | $1.03 | $1.15 | $1.17 | $1.19 | $1.20 |
| FCF/Share | $0.85 | $0.97 | $1.07 | $1.05 | $0.80 | $0.56 |
The company’s sales, profitability, and cash flow differ significantly. Given these tendencies, an investor may suspect the firm is struggling, but the troubles haven’t reached the headline statistics like revenue and profits per share. Several factors may create these issues:
Investment in Growth
Management investing in property, plant, and equipment to develop a firm may produce divergence patterns. In the prior scenario, an investor could see if CapEx was expanding between 2019 and 2021. If FCF + CapEx keeps rising, the stock’s value may be boosted.
Putting Up Stock
Poor inventory control might cause low cash flows. Too many resources spent warehousing unsold items might reduce cash flow for a corporation with excellent sales and income. Based on these numbers, a cautious investor may assume the firm has weak demand or lousy cash management.
Credit Issues
Working capital might alter due to inventory variations or shifts in accounts payable and receivable.
If sales are low, a corporation may provide better payment terms to customers, lowering FCF.
Maybe a company’s suppliers are less inclined to grant credit and want speedier payment. Accounts payable will decrease, lowering FCF.
This credit issue plagued numerous solar enterprises in the late 2000s and early 2010s. Offering better terms to customers might boost sales. Due to industry awareness, suppliers were less eager to extend terms and expected solar businesses to pay them sooner.
FCF analysis showed the essential trend divergence, although the income statement did not.
Calculating Free Cash Flow?
There are two ways to calculate FCF.
The first method starts with cash flow from operational operations and adjusts for interest expense, the tax shield on interest expense, and any CapEx that year.
The second method starts with EBIT and adjusts for income taxes and non-cash expenditures, including depreciation and amortization, working capital changes, and CapEx.
Both methods should provide equivalent statistics, but financial data may favor one.
What does FCF mean?
The annual free cash flow is free of internal and external liabilities.
It represents funds the corporation may safely invest or distribute to shareholders.
Investors usually like robust FCF metrics, but it’s crucial to understand the context. A corporation may have high FCF because it delays CapEx spending, which might indicate future issues.
How Important Is FCF?
Free cash flow is an essential financial indicator since it shows a company’s cash. A corporation with a low or negative FCF may need expensive fundraising to survive.
If a firm has enough FCF to continue operations but not enough to grow, it may lag behind its rivals.
FCF helps yield-oriented investors assess a company’s dividend sustainability and chances of growing it.
Bottom Line
Investors assessing a company’s shares and bankers contemplating lending money might benefit from checking its free cash flow (FCF) and trajectory.
Shareholders can utilize FCF (less interest payments) to assess the company’s dividend or interest capabilities.
Banks can use FCF to assess a company’s debt capacity.
Luckily, nobody must manually compute this amount. For publicly listed corporations, most financial websites give an FCF summary or trend graph.
Correction, 11/10/2022:A previous version of this article misclassified client payments as outflows when they are inflows.
Conclusion
- The cash a firm pays creditors and investors as dividends and interest is its free cash flow (FCF).
- Management and investors evaluate a company’s financial health using free cash flow.
- FCF reconciles net income by adjusting for non-cash expenses, working capital movements, and capital expenditures.
- It might show underlying issues before the income statement.
- Positive free cash flow doesn’t always signify stock strength.
