Free cash flow

What Is Free Cash Flow?

Free cash flow (FCF) represents the cash a company generates after accounting for the cash outflows needed to support its operations and maintain its capital assets. It is a vital financial metric used within financial analysis to assess a company's financial flexibility and overall health. Unlike net income, free cash flow provides a truer picture of the cash a business can generate, as it excludes non-cash expenses like depreciation and amortization and includes actual cash outlays for investments in property, plant, and equipment. A strong free cash flow indicates a company's ability to pay down debt, issue dividends, repurchase shares, or invest in future growth opportunities.

History and Origin

The concept of free cash flow gained prominence in financial discourse in the 1980s. Michael Jensen, an economist, is credited with introducing the concept in 1986 in the context of the agency problem. Jensen defined FCF as the "cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital."¹⁴, ¹⁵ While he did not propose a specific calculation method, his work highlighted how substantial free cash flow could exacerbate conflicts of interest between a company's management and its shareholders regarding payout policies.¹³ Since then, free cash flow has evolved into a popular metric among financial analysts and researchers, albeit with various calculation methodologies emerging over time.¹²

Key Takeaways

• Free cash flow (FCF) measures the cash a company generates after covering its operating expenses and capital investments.
• It offers insight into a company's financial health and its capacity for discretionary spending, such as paying dividends or reducing debt.
• FCF differs from net income by focusing purely on cash movements and factoring in capital expenditures.
• Positive free cash flow suggests a company has sufficient cash to fund growth, return capital to investors, or strengthen its balance sheet.
• Negative free cash flow, especially over an extended period, may indicate financial strain or significant investment in growth.

Formula and Calculation

The most common approach to calculating free cash flow begins with cash flow from operating activities and then subtracts capital expenditures. This method provides a clear view of the cash generated by a company's core operations that is "free" to be used for other purposes.

The formula is expressed as:

Where:

• Cash Flow from Operating Activities (CFO): Found on the cash flow statement, this represents the cash generated from a company's normal business operations.
• Capital Expenditures (CapEx): Also found on the cash flow statement (typically under investing activities), these are funds spent by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment.

Alternatively, FCF can be derived starting from a company's income statement figures, though this involves more adjustments:

Where:

• EBIT (Earnings Before Interest and Taxes): A measure of a firm's profit that includes all revenues and expenses except interest expenses and income tax expenses.
• Tax Rate: The effective tax rate applicable to the company.
• Change in Working Capital: The difference in current assets minus current liabilities from one period to the next, excluding cash and marketable securities. An increase in working capital typically consumes cash, while a decrease generates cash.

Interpreting the Free Cash Flow

Interpreting free cash flow involves more than just looking at a positive or negative number; context is crucial. A consistently positive and growing free cash flow generally signals a healthy and financially flexible company. Such a company has sufficient cash to meet its operational needs, invest in growth, and reward its investors.

Conversely, a negative free cash flow, particularly over a prolonged period, might indicate that a company is struggling to generate enough cash from its operations to cover its investments. However, a temporary negative free cash flow can also be a sign of aggressive growth, where a company is investing heavily in new assets or expansions, which may yield significant future returns. For instance, a startup in a high-growth industry might show negative FCF for several years as it scales its operations. Analysts often evaluate free cash flow in relation to revenue growth, profitability, and industry trends to gain a comprehensive understanding of a company's financial position.

Hypothetical Example

Consider "Tech Innovations Inc." with the following financial data for the fiscal year:

• Cash Flow from Operating Activities: $15,000,000
• Capital Expenditures: $4,000,000

To calculate Tech Innovations Inc.'s free cash flow:

In this scenario, Tech Innovations Inc. generated $11,000,000 in free cash flow. This means that after covering all its operational costs and making necessary investments in its assets, the company has $11 million in cash that it can use for various purposes, such as returning value to shareholders through dividends or stock buybacks, reducing outstanding liabilities, or funding strategic acquisitions. This example highlights the direct and practical measure free cash flow provides for evaluating a company's cash-generating efficiency.

Practical Applications

Free cash flow is widely used across various aspects of finance, offering a clear and less manipulable view of a company's financial strength compared to other accounting measures.

• Company Valuation: Many analysts and investors use free cash flow in discounted cash flow (DCF) models to estimate a company's intrinsic value. By projecting future free cash flows and discounting them back to the present, they can arrive at a fair value for the business or its equity.
• Credit Analysis: Lenders and credit rating agencies examine a company's free cash flow to assess its ability to generate sufficient cash to service its debt obligations. A robust free cash flow indicates a lower credit risk.
• Capital Allocation Decisions: Corporate management uses free cash flow to make decisions about how to best deploy excess cash. This could include reinvesting in the business, making acquisitions, repurchasing shares, or paying dividends to shareholders.
• Mergers and Acquisitions (M&A): In M&A deals, potential acquirers often analyze the target company's free cash flow to determine its capacity to generate cash independently and contribute to the acquiring firm's overall financial health.
• Non-GAAP Reporting: While not a Generally Accepted Accounting Principle (GAAP) measure, companies often report free cash flow as a supplemental financial metric in their earnings releases and filings with the U.S. Securities and Exchange Commission (SEC) to provide additional insight into their liquidity and performance.¹¹

Limitations and Criticisms

Despite its utility, free cash flow is not without limitations. One primary criticism is the lack of a standardized definition and calculation method across companies and industries. Different companies may include or exclude certain items, such as acquisitions or leases, when calculating their free cash flow, making comparisons challenging.⁹, ¹⁰

Additionally, free cash flow can be volatile and "lumpy" from period to period, especially for companies with significant capital expenditures. A large one-time investment in a new facility or equipment can cause free cash flow to dip substantially in a given year, even if the company's underlying operations are strong.⁸ This lumpiness can make it difficult to discern underlying trends without careful analysis of the company's investment cycles.

Management also has some discretion that can impact reported free cash flow. For example, delaying capital expenditures or accelerating the collection of accounts receivable can temporarily inflate free cash flow, but these actions may not be sustainable or beneficial in the long term.⁷ Therefore, it is essential for analysts to scrutinize the components of free cash flow and consider the context of a company's business model and industry when using this metric.

Free Cash Flow vs. Net Income

Free cash flow and net income are both crucial financial indicators, but they measure different aspects of a company's financial performance and are often confused. The fundamental distinction lies in their basis: net income is an accounting measure reflecting profitability under accrual accounting, while free cash flow is a cash-based measure reflecting a company's actual liquidity and cash-generating ability.

Net income, found on the income statement, accounts for revenues when earned and expenses when incurred, regardless of when cash actually changes hands. It includes non-cash items like depreciation and amortization. Free cash flow, on the other hand, starts with cash flow from operations and subtracts capital expenditures, providing a direct measure of the cash available after maintaining and expanding the business. This focus on actual cash transactions means FCF can offer a more accurate picture of a company's financial health, as it is less susceptible to accounting manipulations. For example, a company can report a positive net income but still have negative free cash flow if it has significant non-cash expenses or large capital investments.⁴, ⁵, ⁶ Conversely, a company might show positive free cash flow even with a net loss, especially if it has substantial non-cash depreciation charges.³ Therefore, understanding both metrics is essential for a holistic financial assessment.

FAQs

What does positive free cash flow mean for a company?

Positive free cash flow indicates that a company is generating more cash from its operations than it needs to reinvest in its assets. This excess cash can then be used for various purposes such as paying down debt, issuing dividends to shareholders, repurchasing shares, or funding future growth initiatives. It generally signals financial strength and flexibility.²

Is higher free cash flow always better?

While a high free cash flow is often seen as a positive sign, it is not always indicative of superior performance in isolation. For instance, a company might have high FCF because it is delaying necessary capital expenditures, which could harm its long-term competitiveness. Conversely, a company with low or negative FCF might be investing heavily in growth projects that promise significant future returns. Context, including industry, business stage, and strategic objectives, is crucial for proper analysis.

How does free cash flow relate to a company's valuation?

Free cash flow is a primary component in many valuation models, particularly the discounted cash flow (DCF) model. In a DCF model, future free cash flows are projected and then discounted back to their present value to arrive at an estimated intrinsic value of the company's equity or the entire firm. This approach is favored by many investors because it focuses on the actual cash a business can generate, which is ultimately what investors can receive.

Can a profitable company have negative free cash flow?

Yes, a profitable company can have negative free cash flow. This often occurs when a company is growing rapidly and making significant capital expenditures to expand its operations, purchase new equipment, or invest in research and development. While these investments consume cash, they are essential for future growth and profitability, even if they result in a temporary period of negative free cash flow.¹