What Is Free Cash Flow (FCF)?

What Is Free Cash Flow (FCF)?

Let me explain free cash flow (FCF) directly: it's the cash a company has left after covering the costs to run and maintain its operations and capital assets. You, as an investor or analyst, should rely on it as a solid measure of profitability.

Unlike earnings or net income, FCF cuts out non-cash expenses from the income statement. It factors in spending on equipment, other assets, and shifts in working capital from the balance sheet. This gives you a clearer picture of actual cash availability.

Understanding Free Cash Flow (FCF)

FCF is the cash on hand that a company can use to pay back creditors, distribute dividends, or cover interest for investors. It's essentially free for settling obligations without restrictions.

I recommend considering FCF or FCF per share over earnings or EPS for profitability checks, since it strips out non-cash items. That said, because it includes investments in property, plant, and equipment, FCF can fluctuate unevenly, which might complicate your analysis.

If you're an investment banker or analyst evaluating performance under different capital structures, look at variations like free cash flow to the firm or to equity—these adjust for interest and borrowings.

Calculating Free Cash Flow

To calculate FCF, start with cash flows from operating activities on the cash flow statement—it's already adjusted for non-cash expenses and working capital changes.

You can also use the income statement and balance sheet. For instance, begin with earnings before interest and taxes (EBIT), then adjust for taxes, non-cash items like depreciation, working capital shifts, and capital expenditures.

Other elements from these statements work too. If EBIT isn't available, derive it similarly to reach the same FCF figure. Remember, interest payments are typically excluded from standard FCF definitions.

Benefits of Using Free Cash Flow

FCF stands out as a profitability and health metric because it includes working capital changes, offering you insights into value, efficiency, and trends that the income statement misses.

For example, a drop in accounts payable might signal vendors demanding quicker payments, while rising accounts receivable could indicate collection issues, hurting cash flow. Increased inventory might mean unsold stock piling up.

Analyzing FCF can uncover problems before they hit the income statement. Suppose a company shows steady $50 million net income yearly for a decade—it looks stable. But if FCF has been declining lately due to rising inventories or payment delays, that's a red flag for future issues.

For you as a potential shareholder or lender, deduct debt payments from FCF to gauge dividend or interest reliability. Using FCF minus interest helps predict dividend stability.

Limitations of Using Free Cash Flow

FCF isn't perfect. One issue is that depreciating purchases are fully subtracted in the year they're made, not spread out, which can distort short-term views.

Take a company with $1 million EBITDA, no working capital change, but an $800,000 equipment buy. FCF drops to $200,000 that year, even if EBITDA stays steady next year. You need to investigate why and if it'll persist.

Depreciation methods affect this too—book method spreads costs, reducing net income more than FCF initially, while tax method might align them sooner.

Calculating FCF manually is time-consuming since it's not a standard line item, but tools like Excel make it feasible. It's worth the effort for verifying reported profits.

Interpreting Free Cash Flow

Positive FCF doesn't always match strong stock trends, and the reverse can happen. Focus on trends over time rather than absolute values for better insights.

If FCF is stable over four to five years, bullish stock trends are more reliable. Falling FCF, especially diverging from earnings or sales, signals higher risk of price drops.

Example of Free Cash Flow

Consider Company XYZ with rising sales and EPS from 2017 to 2021, but FCF per share dropping sharply by 2021. This divergence suggests underlying issues despite strong headlines.

Possible reasons include heavy investments in growth (check if CapEx is rising positively), inventory stockpiling indicating poor control, or credit problems like extended customer terms or tighter supplier demands.

Solar companies in the late 2000s faced similar issues, where FCF revealed credit strains not evident in income statements.

How Is Free Cash Flow Calculated?

Two approaches: Start with operating cash flow, adjust for interest, tax shields, and CapEx. Or begin with EBIT, adjust for taxes, non-cash expenses, working capital, and CapEx. Both should match.

What Does Free Cash Flow Indicate?

It shows cash free of obligations, available for investment or distribution. High FCF is positive, but if it's from skimping on CapEx, future problems could arise. Use it with other metrics.

How Important Is Free Cash Flow?

It's crucial as it reflects disposable cash. Low or negative FCF might force fundraising, hinder growth, or jeopardize dividends. For yield investors, it signals payment reliability.

The Bottom Line

Track FCF and its trends to evaluate stock potential. It gauges dividend or debt capacity, though you must calculate it manually. Many sites provide FCF summaries for public companies.