Free Cash Flow

Free Cash Flow

An Introduction to Free Cash Flow

The financial statement of a company offers a wealth of useful data for potential investors, such as Net Profit, Revenue, EBITDA, Profit After Tax, and more. While we already know what most of these terms mean, let us turn our attention to an important yet often overlooked one: free cash flow.

Free cash flow is the amount of money a company can use at its sole discretion. It is often the cash left over after paying for day-to-day operations, emergency reserves, taxes and asset maintenance. A company can use its free cash flow to repay creditors or distribute dividends and interest to its stakeholders. 

Savvy investors often refer to the free cash flow as a signal for a company's financial health because while other numbers, such as profit generation, signal the current status of a company, free cash flow can signify its prospects for growth in the future. After all, even if a company is reporting record profits, if all of the profits are going towards operations, it is hard to gauge how long the company will be able to maintain this streak. 

To put it simply, free cash flow is the surplus cash available to a company. 

Free Cash Flow Calculation

Since the free cash flow still needs to comply with the same financial disclosure rules as other line items, it is sometimes difficult to locate the free cash flow on a company's financial statement.

Suppose the company's financial statement does not mention free cash flow. In that case, you can still calculate it by referring to these other data points that are often found in Income Statements, Statements of Cash Flows & Balance Sheets:

Formula 1

Free Cash Flow = Cash Flow from Operating Activities +Interest Expense -Tax Shield on Interest Expense -Capital Expenditures 

Formula 2

Free Cash Flow = EBIT x (1- Tax Rate) + Non-Cash Expenses (Depreciation, Amortisation, etc.) - Change in (Current Assets - Current Liabilities) - Capital Expenditures 

What Does Free Cash Flow Signify?

Essentially, the free cash flow signifies a company's proficiency and liquidity.

Here is how you can decode changes in the free cash flow:

  1. An increase in FCF could be due to any of the following factors -
  • Asset sale or the closure of a big deal
  • Reduction in capital expenditure or marketing & maintenance
  • Delays in paying salaries or accounts 
  1. Similarly, a decrease in FCF could signify -
  • Investment in equipment
  • Rapid cash-intensive growth 
  • Large orders of stock

Advantages of Calculating Free Cash Flow 

As we have seen above, calculating free cash flow can sometimes be time-consuming, involving deep dives into a company's financials. However, there are quite a few advantages to be gleaned:

  • Reveals discrepancies in the fundamentals before they arise on the income statement
  • It helps investors determine whether a company pays dividends
  • Aligns available cash with the company's profitability
  • It helps creditors gauge a company's repayment ability
  • Aids creditors in their decision to sanction loan amounts
  • Allows potential partners to evaluate the viability of a company's operations

Risks Concerned with Relying on Free Cash Flow 

It is important to have the free cash flow metric in mind. However, one shouldn't base all of their investment decisions on this number. Where there are advantages, there are always risks involved. Here's why you should always consider free cash flow in context with the other variables: 

  • Positive free cash is only sometimes associated with upward trends in a company's equity. Markets move because of various factors, and even companies with strong free cash flows are susceptible to downward share performance
  • Sometimes, there are companies whose business model dictates negative free cash flow. In recent times, we have seen giants like Amazon and Uber grow tremendously by reinvesting profits into operations and even incurring losses to promote market dominance. Similarly, investment-heavy sectors like power and mining will always be in a cash crunch due to the industry's nature.
  • Capital expenditure is a variable that shifts from year to year, making it vital to measure the free cash flow in context with the company's performance over time among its peers in the industry.
  • A concern for companies hosting high amounts of free cash flow is that they may not be investing enough in the growth of their business venture.

Therefore, bear in mind that free cash flow is just another tool that aids your analysis of a company's profitability in conjunction with other financial instruments.