Free Cash Flow

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Free Cash Flow

Free Cash Flow (FCF) is a measurement of a company's financial performance and health. FCF represents the cash a company can generate after required investment to maintain or expand its asset base. Free Cash Flow provides a useful valuation technique investors often use to derive a firm's value or the value of a firm's common equity. Often, investors will calculate a firm's value using FCF valuation model techniques and subtract net debt to arrive at a company's equity value in a simple capital structure.

Free Cash Flow Calculations

There are several methods for calculating free cash flow, but reporting requirements make it really easy to calculate for publicly traded companies. The FCF calculation usually begins with "Cash Flow From Operating Activities", but it can also start from revenue or "Net Operating Profit After Taxes". If calculated properly with all the same inputs, this equations should produce the same result for FCF. Free cash flow can be a tremendously useful measure for understanding the true profitability of a business. It's harder to manipulate and it can tell a much better story of a company than more commonly used metrics like net income.

  • FCF = Cash Flow From Operating Activities - Capital Expenditures

  • FCF = Net Operating Profit After Taxes - Net Investment in Operating Capital

  • To calculate a price-to-free-cash-flow ratio, you can simply divide the price of a share by the free-cash-flow per share, or the market cap of a company divided by its total free cash flow.

Here is the example how to calculate the FCF of Company X

The company x wants to expand into new territories and wants to bring on new investors. The new investors want to analyze the company x free cash flow to see if it would be worth their time. To calculate FCF, from the cash flow statement, we'll find the item "Cash Flow From Operating Activities" (also referred to as "operating cash" or "net cash from operating activities") and subtract capital expenditure required for current operations from it.

The company x cash flow statement:

  • Cash Flow From Operating Activities:$9.000,000

  • Capital Expenditures: $4.500,000

FCF = Cash Flow From Operating Activities - Capital Expenditures = $4.500,000

In this example, we can see that company x has a significant amount of free cash flow, which can be used to pay dividends, expand operations, and deleverage its balance sheet, i.e. reduce debt.

FCF is an important measure because it allows a company to pursue opportunities that enhance shareholder value. Excess cash can expand production, develop new products, make acquisitions, pay dividends and reduce debt. As FCF increases, balance sheet strength and health rises; however, it is important to note that negative FCF is not usually a bad indicator. If FCF is negative, it could be a sign a company is making significant investments. If these investments earn high returns, the strategy has the potential to add value in the long run. On the other side, there can be a variety of situations in which a company can report positive free cash flow, and which are due to circumstances not necessarily related to a healthy long-term situation. For example, positive free cash flow can be caused by:

  • Cutting back on or delaying capital expenditures

  • Delaying the payment of accounts payable

  • Selling off major corporate assets

  • Accelerating receivable receipts with high-cost early payment discounts

In the examples above, the management of the company has taken steps to reduce the long-term viability of a business in order to improve its short-term free cash flows. Free cash flow can also be impacted by the growth rate of a business. If a company is growing rapidly, then it requires a significant investment in accounts receivable and inventory, which increases its working capital investment and therefore decreases the amount of free cash flow. Companies that are capital light, meaning they don't have to make long-term investments as part of their business, will have very steady free cash flow over time. Free cash flow for a capital-light business will usually approximate net income.

Free Cash Flow basically just measures how much extra cash the business will have after it pays for all of its operations and fixed asset purchases. It is important to understand that FCF doesn't tell you everything but observing that there is a very big difference between income and free cash flow will almost certainly make you a better investor. Value investors often look for companies with high or improving cash flows but with undervalued share prices. Rising cash flow is often seen as an indicator that future growth is likely.

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