The Key To Real Value
One number often stands out when evaluating the health of a business. It is considered a true measure of financial strength: free cash flow (FCF). While earnings and revenue get a lot of attention, free cash flow provides even more crucial information. It shows how much actual cash is left over after a company pays its bills and invests in its operations.
1. What is Free Cash Flow?
Free cash flow shows the cash a company generates from its operations. This is calculated after accounting for the money it spends to keep and grow its business. In simple terms, it’s the cash a company has left once it’s paid for:
- Operating expenses (salaries, rent, utilities, etc.)
- Taxes
- Capital expenditures (buying or upgrading property, equipment, or technology)
This “free” cash is available for distribution to shareholders. It can also be used for paying down debt. Another option is reinvesting in the business or saving for future opportunities.
2. How is Free Cash Flow Calculated?
The basic formula is:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
- Operating Cash Flow (OCF) is found on the company’s cash flow statement. It shows how much cash is generated from day-to-day business activities.
- Capital Expenditures (CapEx) are the funds spent on long-term assets like buildings, machines, or software.
Example:
If a company has $10 million in operating cash flow and spends $4 million on capital expenditures, its free cash flow is:
$10 million – $4 million = $6 million
3. Why Free Cash Flow Matters
Free cash flow is important for several reasons:
- Financial Health Indicator: Positive FCF means a company is generating more cash than it needs to uphold operations. This is a sign of strength.
- Flexibility: Companies with strong FCF can pay dividends. They can also repurchase shares, pay down debt, or invest in growth. They do not need outside financing for these activities.
- Value Investing Metric: Many investors consider FCF more reliable than reported earnings. It’s harder to manipulate and it reflects real cash in the bank.
- Debt Management: Consistent free cash flow can help a company handle downturns and still meet its debt obligations.
4. Positive vs. Negative Free Cash Flow
- Positive FCF: Indicates the company is generating excess cash after covering expenses and investments. This is generally a good sign.
- Negative FCF: Means the company is spending more on capital projects than it is generating in cash. This isn’t always bad. Startups or growing companies often have negative FCF as they invest heavily for future growth. Nevertheless, it can be a warning sign if it persists without a clear payoff.
5. Real-World Example
Imagine TechGrow Inc. has:
- Operating Cash Flow: $500 million
- Capital Expenditures: $200 million
Free Cash Flow = $500M – $200M = $300M
With $300 million in free cash flow, TechGrow will:
- Pay $100 million in dividends to shareholders
- Assign $150 million for strategic acquisitions
- Keep $50 million as a cash reserve
Conclusion
Free cash flow is a crucial metric for investors, lenders, and company management alike. It simplifies accounting complexities to show how much cash a company truly has available. This helps in growing the business, rewarding shareholders, or strengthening its balance sheet. Whether you’re analyzing a blue-chip stock or a small startup, understand free cash flow. This knowledge can help you separate financially strong companies from those just treading water.
