The term “free cash flow” refers to a measure of cash flowing into a company from sales, royalties, etc. minus capital expenditures paid out. In simpler terms, free cash flow (FCF) simply represents the cash that a company is able to generate after laying out the money required to maintain or expand its business.
When it comes to reporting earnings and income, there are certain things that companies can do to make the numbers appear in the best light possible. For example a company may stretch out the time it takes to pay certain bills, it may push to collect receivables faster and/or it may carry less inventory on the books. Actions such as these may help make the current quarter or year’s earnings look strong, but can be to the long-term detriment of the firm.
Analyzing free cash flow can sometimes help traders to “see through” certain accounting gimmicks and to get a better idea of how well a company handles income and expenses as they pass through the company. This is important for the simple reason that higher cash flow allows a company greater opportunity and flexibility to enhance shareholder value. A company with strong free cash flow can develop new products, make acquisitions, pay dividends and reduce debt more easily than a company with weak free cash flow.
Components of free cash flow
Some analysts will use slightly different formulas to arrive at their free cash flow figure for a given company. But the most commonly recognized formula for calculating free cash flow is:
Earnings + Interest + Taxes + Depreciation + Amortization - Change in Net Working Capital* - Capital Expenditures
* - Net Working Capital is simply the change from one year to the next in current assets such as cash, receivables, marketable securities and inventory minus current liabilities such as accounts payable, accrued liabilities and debt maturing within one year.
This one is relatively simple. In a nutshell, “Consistency is good, more is better and consistently more is best.” If you think about it in terms of how you run your own household budget, it becomes very clear. For example, if you are taking in more money from wages and/or investments than you are spending on monthly expenses, then at the end of the month you have cash left over.
The more income you bring in and the more you reduce your monthly expenses, the more cash you have leftover at the end of the month. The more cash you have left over at the end of the month – and the more consistently that that is the case, the more flexibility you have.
What traders look out for
A sharp decline in cash flow from previous historical levels may be a warning sign that something negative is happening within a company’s operations. And of course, negative cash flow – where a company is laying out more cash than it is taking in – is typically a serious red flag as this is obviously a situation that can only go on for so long before the company finds itself in serious financial trouble.
One of the things that drives the success of any company is the flexibility they have in being able to take advantage of opportunities to grow their existing business and to expand into new areas. In most all cases this flexibility requires investment dollars. The more free cash flow that a company can generate the greater the flexibility they will enjoy in terms of taking advantage of opportunities to grow their business.