Free Cash Flow is a very useful metric for investors when assessing a company as it provides insight into the viability of the company to fund its own growth and development. Additionally, it can be an indicator of the ability of the company to have cash available to pay dividends going forward.
The basic calculation for Free Cash Flow is:
Free Cash Flow = Cash Flow from Operations – Capital Expenditures
Cash Flow from Operations and capital expenditures can both be easily obtained directly from a company’s cash flow statement. There are other formulas for calculating Free Cash Flow but they all arrive at the same number and require more inputs than the basic calculation above.
Free Cash Flow shows you what cash a company is generating from its operations after it has paid for any necessary capital expenditures. If a company consistently shows a positive Free Cash Flow it is a good indicator that it will be able to pay dividends and fund growth without the need to obtain financing, which would increase the financing costs related to future income. Additionally, as a consistent Free Cash Flow demonstrates a high degree of financial health in a company it does have a bearing on future stock prices.
A consistently negative Free Cash Flow balance is generally considered to be an indicator of a company that is in trouble as they will have to regularly fund their operations through financing, thereby reducing future income. A single year having a negative Free Cash Flow is not necessarily indicative of financial problems at a company as it may have simply made a large capital investment during that period.
That is why looking at a company’s Free Cash Flow trend for several periods is important.
Additionally, as with any financial metric, calculating Free Cash Flow alone will not be very useful. It is a good idea to compare your results to industry benchmarks or direct competitors of the company that you are looking at.
Many investors like to use Free Cash Flow to assess a company’s performance as they believe it is less susceptible to manipulation than income statement accounts like EBITDA and Net Income. The income statement can be manipulated through the use of various accounting practices but actual cash balances are far more difficult to fake.
Some additional methods used to calculate Free Cash Flow include:
Free Cash Flow = Profit after Tax – Changes in Capital Expenditure + Amortization – Changes in Working Capital
Free Cash Flow = Net Profit + Interest Expense – Capital Expenditure – Changes in Working Capital – Tax Shield on Interest Expense
As you can see these formulas represent a far more complex approach to arriving at essentially the same number.