Free cash flow",

What Is Free cash flow?

Free cash flow (FCF) represents the cash a company generates after accounting for Cash Flow from Operations and expenditures required to maintain or expand its asset base, known as Capital Expenditures. It is a crucial metric within Financial Analysis that indicates the cash truly available to a company's investors, including both equity and debt holders, without hindering its ongoing operations or future growth. Unlike reported accounting profits, free cash flow focuses on a company's true Liquidity and its ability to generate actual cash, making it a valuable tool for assessing a company's financial health and potential for shareholder returns.

History and Origin

The concept of free cash flow gained significant prominence in financial theory, particularly with the work of academic Michael C. Jensen in the mid-1980s. Jensen's seminal paper, "Agency Costs of Free Cash Flow: Corporate Finance and Takeovers," published in 1986, highlighted how conflicts of interest between managers and shareholders could arise, especially when firms possess substantial free cash flow. He posited that managers might be inclined to invest excess cash in unprofitable projects or make value-destroying Acquisitions rather than distributing it to shareholders, a phenomenon he termed "Agency Costs". This academic contribution underscored the importance of free cash flow as a critical factor in corporate governance and investment decisions, moving it beyond a mere accounting figure to a central element in understanding corporate behavior and shareholder value creation. His paper is widely cited in corporate finance literature⁸, ⁹, ¹⁰, ¹¹.

Key Takeaways

• Free cash flow represents the cash a company has left after paying for its operating expenses and capital investments.
• It is a strong indicator of a company's financial health and its ability to generate surplus cash.
• FCF can be used for various purposes, including paying Dividends, executing Share Repurchase programs, reducing Debt, or investing in new growth opportunities.
• Unlike Net Income, free cash flow is less susceptible to accounting manipulations and provides a clearer picture of actual cash generation.

Formula and Calculation

The most common approach to calculating free cash flow is by starting with Cash Flow from Operations and subtracting Capital Expenditures.

The formula is expressed as:

Where:

• Cash Flow from Operations: The cash generated by a company's normal business activities before any financing or investing activities. This figure can be found on the Financial Statements, specifically the cash flow statement.
• Capital Expenditures: Funds used by a company to acquire, upgrade, and maintain physical assets such as property, plants, buildings, technology, or equipment. These are typically listed under investing activities on the cash flow statement.

Another way to calculate free cash flow, often referred to as Free Cash Flow to Firm (FCFF), starts from earnings before interest and taxes (EBIT) and adjusts for non-cash expenses, taxes, and investments in Working Capital and capital expenditures.

Interpreting the Free cash flow

Interpreting free cash flow involves evaluating its magnitude, trend, and stability. A consistently positive and growing free cash flow indicates a financially healthy company that can fund its growth, pay down debt, and return value to shareholders without relying on external financing. A high free cash flow suggests strong operational efficiency and Profitability. Conversely, negative free cash flow, especially over an extended period, might signal that a company is struggling to generate sufficient cash from its core operations or is heavily investing in growth, which could strain its liquidity if not managed effectively. It's important to consider the industry context; rapidly growing companies, for instance, might have lower or even negative FCF due to significant capital investments, while mature companies are expected to generate substantial FCF.

Hypothetical Example

Consider "InnovateTech Inc.", a technology company, reporting its financial performance for the year.

• InnovateTech's Cash Flow from Operations: $500 million
• InnovateTech's Capital Expenditures: $150 million

To calculate InnovateTech's free cash flow:

This $350 million in free cash flow indicates that after covering its operational costs and investing in its essential infrastructure, InnovateTech Inc. has $350 million available. This cash can be used for purposes such as issuing dividends, buying back shares, or paying down existing Debt.

Practical Applications

Free cash flow is a vital metric for investors and analysts in various real-world scenarios:

• Valuation Models: FCF is a primary input in Valuation models, particularly the Discounted Cash Flow (DCF) model, where future free cash flows are projected and then discounted back to the present to estimate a company's intrinsic value. This method is widely used by financial professionals to determine whether a company's stock is undervalued or overvalued.
• Dividend Sustainability: A company with robust free cash flow is better positioned to consistently pay and potentially increase its dividends, as dividends are paid from actual cash, not just accounting profits.
• Debt Repayment Capacity: Strong free cash flow enables companies to service and repay their debt obligations, reducing financial risk and improving their creditworthiness.
• Mergers and Acquisitions (M&A): Acquirers often assess the target company's free cash flow to determine its ability to generate cash for debt repayment or future expansion.
• Capital Allocation Decisions: Management teams use free cash flow to decide how to best allocate capital, whether through reinvestment in the business, debt reduction, or returning capital to shareholders. Companies like Apple Inc. regularly disclose their cash flow figures, including free cash flow, in their annual Form 10-K filings with the U.S. Securities and Exchange Commission, providing transparency into their cash-generating abilities⁵, ⁶, ⁷. Financial research firms also emphasize the importance of free cash flow in fundamental analysis as a crucial measure of a company's financial strength⁴.

Limitations and Criticisms

While free cash flow is a powerful metric, it is not without limitations. One criticism is its potential for volatility, which can make a single year's free cash flow less indicative of a company's true operating health compared to earnings. The calculation of free cash flow can also be subject to varying definitions and adjustments, leading to inconsistencies across different analyses. For example, some definitions of free cash flow include or exclude certain items, leading to different results. Professor Aswath Damodaran has noted that free cash flow is "one of the most dangerous terms in finance," often bent to mean whatever investors or managers desire, and that it may not always be a better measure of a company's value than accounting earnings in a pricing context², ³.

Furthermore, periods of high growth may see lower or negative free cash flow due to significant reinvestment in the business, which is not necessarily a negative sign. Investors should consider the company's life cycle and industry. Additionally, relying solely on free cash flow without considering other financial statements and qualitative factors could lead to an incomplete assessment of a company's overall financial health and future prospects.

Free cash flow vs. Net Income

Free cash flow and Net Income are both important measures of a company's financial performance, but they represent different aspects. Net income, also known as profit or earnings, is a measure of a company's Profitability calculated based on accounting principles (accrual accounting). It reflects revenues less expenses, including non-cash items like depreciation and amortization. A company can report a high net income but still have a cash shortage if, for instance, many sales are on credit and payments are not yet received¹.

In contrast, free cash flow is a measure of a company's cash-generating ability and its Liquidity. It focuses on the actual cash available after all operational expenses and necessary capital investments are made. Because it excludes non-cash accounting entries, free cash flow provides a more direct view of the cash a company can use to repay debt, pay dividends, or fund expansion. While net income indicates how profitable a company is on paper, free cash flow shows how much cash it truly generates to sustain and grow its operations.

FAQs

What is the primary purpose of free cash flow?

The primary purpose of free cash flow is to show the actual cash a company generates that is available to distribute to its investors (both Equity and debt holders) or to reinvest in the business, after covering all operating expenses and necessary capital investments. It offers a clear picture of financial flexibility.

Can a company have negative free cash flow?

Yes, a company can have negative free cash flow. This often happens when a company is in a growth phase, investing heavily in new assets, research and development, or Acquisitions. While prolonged negative FCF can be a concern, short-term negative FCF can be a sign of strategic investment for future growth.

Why is free cash flow considered more reliable than net income?

Free cash flow is often considered more reliable than Net Income because it deals with actual cash inflows and outflows, making it less susceptible to accounting manipulations or non-cash expenses like depreciation and amortization that can impact reported earnings. It provides a truer measure of a company's cash-generating capacity.

How do investors use free cash flow?

Investors use free cash flow to evaluate a company's financial health, its ability to pay dividends, repurchase shares, reduce Debt, and fund future growth. It is also a key component in Valuation models, such as the Discounted Cash Flow method, to estimate a company's intrinsic value.