Free Cash Flow - Explained
What is Free Cash Flow?
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Table of ContentsWhat is Free Cash Flow?How Does Free Cash Flow Work?Free Cash Flow in Company AnalysisFree Cash Flow CalculationsHow to define Good Free Cash Flow
What is Free Cash Flow?
Free cash flow refers to the cash that a firm has post its cash outflow transactions which it uses for carrying its business activities and sustaining its long-term assets. Free cash flow is not the same as earnings or net income. It ascertains profits excluding the non-cash or non-liquid expenses recorded in the income statement, and includes expenses related to equipment and assets, and variations in working capital. Free cash flow doesn't include interest payments. For ascertaining the estimated performance of a company regarding various capital structures, investment bankers and financial analysts use different types of free cash flow such as free cash flow for the firm and free cash flow to equity. These free cash flow are balanced for interest payments and loans.
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How Does Free Cash Flow Work?
The evaluation of free cash flow is made on the basis of per share so as to analysis the dilution effect. All stockholders, preferred shareholders, and creditors of the company receive cash flow in the form of free cash flow. There are many investors who choose free cash flow or free cash flow per share instead of earnings and earnings per share for determining the financial position of a company. Though FCF accounts are related to property, equipment or plant related investments, it can show inconsistency over a period of time. Lets say, the earnings before depreciation, amortization, interest, and taxes (EBITDA) of a company are $1,000,000 for a specific time period. Also, there were no changes made in the working capital of the company. However, they purchased a machinery of $800,000 at the year end. The costs related to this new machine will be allocated for a time period in the income statement, which balances the effect on earnings. However, since free cash flow represents new machinery in one go, the company will report free cash flow of $200,000, which is the difference between EBITDA and machinery, on EBITDA of $1,000,000. In case, the company makes no additional purchases for machinery, and other things remain constant, the value of FCF will be equivalent to EBITDA in the coming year. In such case, an investor will require to know the reason of free cash flow falling so steadily one year just to get back to prior levels, and if it is likely that such change would persist ahead.
Free Cash Flow in Company Analysis
Since free cash flow exhibits fluctuations in working capital, it can offer important information about the company's goodwill as well as its financial position. For instance, if accounts payable fall, it would signify that vendors require steadier payments from their customers/company. In case, accounts receivables decrease, it signifies that the company is able to collect quick payments from its customers. If there is an increase in inventory, it would signify that the firm is holding a stock of items that have not been sold yet. When the company considers working capital in determining its profits, it gives an insight that its income statement doesn't include. For instance, the annual net income of a company is $50,000,000 for the last 10 years. In spite of such consistency, there can be cases when free cash flow of the company has been falling for the last 2 years. The culprits are increase in inventory, delay in accounts receivables, and increase in accounts payable. This signifies poor financial position of the firm that one could not have estimated by only studying the income statement. Free cash flow also gives an idea to prospective shareholders of the firm in knowing the extent of dividends or interest the firm would be able to pay. In case, the free cash flow of the company excludes the debt payments, it will inform the lender about the quality of cash flows available for more debts. Also, shareholders consider FCF-interest payments in knowing how consistent the prospective dividends would be.
Free Cash Flow Calculations
Free cash flow considers cash flows from operating activities (given in the cash flow statement) as it includes already adjusted income for interest payments, changes that the working capital encountered, and non-cash expenses. Besides income statement, and balance sheet, the company can also use cash flow statement for arriving at free cash flow. For instance, in the absence of EBIT (earnings before income and tax), an investor can use the following approach for getting the right calculation. Free cash flow doesn't require disclosing financial information just like line items in the company's financial books. FCF offers verification of the profitability reports of the company. Even if it is good to do so, every investor doesn't have the strong knowledge, or are not interested in instilling their time in making such manual calculations.
How to define Good Free Cash Flow
Reputed websites like Investopedia offers insights of free cash flow for the majority of the public organizations. However, the main concern is to find out what a good FCF looks like. There can be cases when firm with great or positive FCF show unfavorable stock movements. Also, there can be times when firm with positive FCFs can showcase favorable stock trends. The FCF trends can simplify your observation. As per technical researchers, we can emphasize on patterns associated with the primary performance instead of the absolute figures of free cash flow, income, or sales revenues. In case, the prices of stock are a function of the related fundamentals, then there should be a positive correlation established between the free cash flow and average patterns of stock prices. It is wise to use the consistency of free cash flow for ascertaining the levels of risk. If FCF has been stable for the last 4-5 years, then there would be less possibility of bullish stock patterns getting disrupted ahead. On the other side, declining FCF patterns, particularly the ones that are quite distinct in comparison to sales patterns, and earnings, are a sign of negative price movement. Such method doesn't include the exact value of free cash flow for emphasizing on FCF slope and its link with the price performance.