When it comes to gauging a firm’s financial health, many investors look at a measure known as “free cash flow.” In fact, many see it as a potentially more useful metric than earnings. What is it?
Let’s start by looking at operating cash flow. This is what you get when you take a company’s earnings and adjust them to reflect operating activities that either decrease cash on hand (e.g., selling products on credit rather than for cash) or increase it (e.g., buying raw materials on credit rather than for cash).
Once you know the operating cash flow, you subtract any investments in long-term assets like property and equipment. The result is the company’s free cash flow.
If the figure is positive (and, ideally, growing over time), it means that after maintaining or even expanding its production facilities, a firm has cash left for shareholder-friendly actions such as paying down debt, initiating or increasing dividends or repurchasing shares. A negative number could mean a business isn’t making enough cash to support itself.
So why do some investors find free cash flow a more reliable metric than earnings? There are two reasons.
First, earnings are based on accruals, which is another way of saying “estimates.” For example, if a company sells products on credit—which many do—it assumes it will eventually be paid in cash. Its earnings are an estimate based on that assumption. The trouble is that estimates can be wrong—a recession could make it difficult for customers to pay their bills or inventories may turn out to be obsolete—and the company may have to restate its financial results. That can impact a company’s share price.
Second, because cash transactions aren’t based on estimates and can be verified by audit, they are less subject to manipulation (and outright fraud) than accrual-based earnings measures. No one wants an investigation of accounting fraud to blow a hole in their investment portfolio.
How do you find cash flow information?
You can do your own calculations using a company’s cash flow statement, and some analyst reports include such information. You can also find cash flow information on schwab.com.
Log into your account, click on “Research,” and enter a ticker symbol.
To the right of the stock’s “Summary” page, click on “Statements,” then select “Cash Flow Statement” (both quarterly and annual versions are available).