What is Free Cash Flow?
Free cash flow refers to the amount of cash that remains with a company after paying for the costs necessary to continue operating, including buildings, equipment, salaries, taxes, and inventory. It gives the company the freedom to use this money as it sees fit.
Note: You can find the necessary information to calculate free cash flow in the cash flow statement, income statement, and balance sheet.
How to Calculate Free Cash Flow?
There are several ways to calculate free cash flow, but all should give you the same result. Not all companies provide the same financial information, so investors and analysts use the method to calculate free cash flow that fits the data they have. The simplest way to calculate free cash flow is to subtract the company’s capital expenditures from operating cash flow.
If you are analyzing a company that does not mention capital expenditures and operating cash flow, there are similar equations that determine the same information, such as:
Free Cash Flow = Total Sales Revenue – (Operating Costs + Taxes) – Required Investments in Operating Capital
Free Cash Flow = Net Operating Profit After Taxes – Net Investment in Operating Capital
How Does Free Cash Flow Work?
Positive free cash flow indicates the overall health of a business. Companies with healthy free cash flow have enough cash on hand to meet their monthly bills and more. A company that consistently achieves high or stable free cash flow is usually doing well and may want to consider expansion. A company that consistently achieves low or stable free cash flow may need to restructure because there is little money left after covering bills.
It is not uncommon for investors to seek out companies that achieve rapidly increasing free cash flow because such companies usually have excellent opportunities. If investors find a company that is generating increasing cash flow with a stock price estimated to be undervalued, it is a good investment and may be a target for acquisition.
Limitations of Free Cash Flow
Low free cash flow is not always an indicator of business failure. Even healthy companies experience a decline in free cash flow when actively seeking growth. Business moves such as acquisitions and investments in new product development temporarily siphon off profits. Try to look beyond the numbers. Remember that older, more established companies tend to have more consistent free cash flow, while newer companies are often in a position that channels cash toward stability and growth. The industry of the company also plays a significant role in determining free cash flow – not every company needs to spend money on equipment, land, or inventory.
Note: Free cash flow is a better indicator of financial health for non-financial companies such as manufacturers or service companies, rather than investment firms or banks. It depends on the types of fixed assets required to operate in a particular industry.
Although free cash flow is more reliable than some other calculations, it is not completely immune to accounting manipulation. Regulators have not defined a standard calculation method, so there is some flexibility for accountants. For example, accounts can manipulate the timing of accounts receivable and payables recognition to inflate free cash flow.
Takeaway
Free cash flow measures the amount of cash a company has at its disposal after covering the costs of continuing operations. The simplest way to calculate free cash flow is to subtract capital expenditures from operating cash flow. Analysts may need to make additional or slightly adjusted calculations depending on the data available to them. Free cash flow is best used to analyze non-financial companies that require clear capital investments, such as warehouses, inventory, and manufacturing equipment.
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Sources:
The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy.
Corporate Finance Institute. “Free Cash Flow (FCF).” Accessed July 6, 2020.
Source: https://www.thebalancemoney.com/what-is-free-cash-flow-and-how-can-you-calculate-it-393111
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