A Guide to Free Cash Flow

Free cash flow (FCF) helps eliminate the guesswork in valuation. It is one of the essential components of discounted cash flow analysis. It shows how much money is left over for investors and calculates an accurate number for earnings, so you don’t have to guess the value of the stock.

FCF is the cash available for the company to pay interest and dividends to investors and to pay creditors. It reveals any problems in the company’s fundamentals before they show up on the income statement.

Related: Valuation Basics: The Three Valuation Approaches

Free Cash Flow Explained

Free cash flow (FCF) is the cash the company has after paying for operations and capital assets. It does not cover the non-cash expenses shown on the income statement or interest payments. However, it accounts for spending on assets and changes in working capital shown on the balance sheet.

Analysts and investment bankers seeking to evaluate a company’s expected performance with different structures adjust for interest payments and debt using FCF variations like free cash flow for the firm and free cash flow to equity.

The firm’s free cash flow (FCFF) measures a company’s profitability after taxes, working capital, expenses, and investments. This important benchmark is used to analyze and compare a company’s financial health. A negative FCFF shows that the company did not generate enough revenue to pay for its expenses and investments.

Free cash flow to equity (FCFE) measures equity capital usage that shows the cash available to the company’s shareholders after paying all expenses, reinvestment, and debt. It includes capital expenditures, net income, debt, and working capital. Analysts use FCFE to determine the value of a company and use it as an alternative to the dividend discount model, especially when a company does not pay a dividend.

Analysts also evaluate the effect of dilution by calculating the FCF on a per-share basis. Dilution refers to the diminishing equity positions of shareholders when the company creates or issues new shares. It also reduces earnings per share and negatively impacts share prices.

Free Cash Flow Benefits

FCF provides insight into company value and fundamental trends. As discussed earlier, FCF accounts for changes in the company’s working capital. A decrease in accounts payable indicates that vendors are collecting payments faster. A reduction in accounts receivable shows that cash from customers is coming in quickly. Similarly, a rise in inventory levels indicates low sales. Therefore, FCF provides insight into items missing from the income statement by including working capital to measure profitability.

For example, a company witnesses a stable net income of $30,000,000 for the past ten years. But the FCF may show a declining trend for the last three years as vendors demand faster payments, customers delay payments, or inventories rise.

FCF informs lenders and shareholders whether the company can pay expected dividends and interest. Lenders can gauge the quality of cash flow available with a company by deducting debt payments from FCFF. Similarly, shareholders can predict the expected stability of future dividend payments by reducing interest payments from FCF.

FCF is a reliable measurement. Removing the guesswork from investment decisions makes FCF a valid measurement to evaluate business earnings accurately. It also allows investors to take a close, intrinsic view of stock value and make better decisions by eliminating estimates and uncertainties.

FCF enables investors to differentiate between the stocks that make sense and those likely to create a loss. By reducing risk, they may become aggressive or conservative in building their overall wealth.

Investors can determine where the value of a company lies and if its stock price is currently under or overvalued. They can determine how fast a company needs to grow by working backward from the current stock price and the cash flow model.

Free Cash Flow Downsides

FCF can only work when the company is operating with 100 percent transparency. Analysts cannot use free cash flow as a measurement tool without transparency regarding sales practices, cost trends, and other important information impacting its calculation. There should be complete transparency in the company’s operations to leverage the benefits of the FCF metrics.

No long-term benefit to investing. While FCF helps short-term investors, it is ineffective for long-term investing. Many variables may change year to year, so individuals planning their 401(k) or IRA for retirement in 20 years cannot rely on FCF.

How to Calculate Free Cash Flow

Analysts calculate FCF by starting with cash flow from operating activities (CFOA) on the cash flow statement because the number already adjusts earnings for non-cash expenses and working capital changes.

CFOA determines the financial success of the company’s core business activities. It indicates the money coming in from business activities, such as manufacturing, sales, or services.

A cash flow statement provides aggregate data on all cash inflows and outflows of a company.

Essentially the formula is:

FCF = Operating Cash Flow – Capital Expenditures

When the company does not provide operating cash flow, analysts may use the following formula:

FCF = CFOA + Interest Expense – Tax Shield on Interest Expense – Capital Expenditures

Analysts may also use the balance sheet and income statement to calculate FCF, as shown below:

FCF = EBIT x (1 – Tax Rate) + Non-cash Expenses – Changes (Current Assets – Current Liabilities) during the current and previous periods – Capital Expenditures

Analysts may use other factors from the balance sheet, income statement, and the cash flow statement if EBIT is not available and calculate FCF as follows:

FCF = Net Income + Interest Expense – Tax Shield on Interest Expense + Non-cash Expenses – Current Liabilities (during the current and previous periods) – Capital Expenditures

Importance of Free Cash Flow

FCF accurately represents the cash available within a company. A company might have enough free cash flow to run its operations smoothly but not enough to invest in its growth. That may result in the company falling behind its competitors. Similarly, a company with low or negative FCF might be forced into costly fundraising rounds to remain solvent.

Yield-oriented investors may use FCF to understand the sustainability of a company’s dividend payments and its likelihood of generating future dividends. FCF indicates the cash is clear of obligation (both internal and external) and available for investment or distribution to shareholders.

Seek guidance from best-in-class professionals to understand the free cash flow metric. While a healthy FCF gives positive indications, it is essential to understand the context behind the number. For example, a company that shows high free cash flow, because it is delaying crucial capital investments, may indicate future problems.

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