Free Cash Flow

The cash that a corporation generates after deducting cash outflows for operating expenses and capital asset maintenance is known as free cash flow (FCF). Free cash flow, as opposed to earnings or net income, is a metric of profitability that takes into account changes in working capital from the balance sheet as well as spending on assets and equipment. Additionally, non-cash expenses are eliminated from the income statement.

Understanding Free Cash Flow (FCF)

Free cash flow is the amount of money that a business has left over after paying its bills and dividends and interest to investors and creditors. Because these measurements exclude non-cash items from the income statement, some investors prefer to use FCF or FCF per share as a measure of profitability over earnings or earnings per share. FCF, however, can fluctuate and be inconsistent over time because it takes into account investments in PP&E.

How To Calculate FCF

These are two actual FCF instances from two separate businesses: Nike and Chevron.Let's start with the cash flow statement from Chevron's third-quarter 2020 public disclosure:

Free Cash Flow = Net Cash From Operating Activities - Capital Expenditures

(Net cash provided by operating activities of $8.3 million)-(Capital expenditures of $6.9 million) = Free cash flow of $1.4 million during the first nine months of 2020.

Also, according to Nike's consolidated statement of cash flows report for the second quarter of 2020:

(Cash provided by operations of $3.4 billion)-(Additions to property, plant, and equipment of $344 million) = Free cash flow of $3.02 billion during the six months ended November 30, 2020.

As you can see, FCF is computed for all different types of businesses, including those that need significant investments in real estate and equipment, like Chevron, and those that have a lot of intangible assets, such branding and online stores, like Nike. FCF is a straightforward indicator of cash left over at the conclusion of a specified time period, regardless of what the company performs for business. The corporation can use the leftover funds to pay down debt, distribute dividends to shareholders, or support stock repurchase plans (all of which are recorded in the "financing activities" section of the cash flow statement). A discounted cash flow model can also use the free cash flow figure to project a company's future value.

Benefits Of Free Cash Flow

FCF may offer significant insights into the value of a firm and the health of its basic trends because it takes working capital movements into consideration. A decline in accounts payable (outflow) could indicate that vendors want payments made more quickly. A drop in accounts receivable (inflow) may indicate that customers are paying the business more swiftly. A growing backlog of unsold goods may be indicated by an increase in inventory (outflow). Working capital inclusion adds a dimension to profitability metrics that the income statement neglects.

Limitations Of Free Cash Flow

Consider a business with $1,000,000 in profits before interest, taxes, depreciation, and amortization ((link: https://fincent.com/blog/all-about-ebitda-and-how-to-calculate-it-for-your-business text: EBITDA)) per year. Assume further that this company's working capital (current assets minus current liabilities) has not changed, but that at year's end, $800,000 worth of new equipment was purchased. Depreciation on the income statement will be used to stretch out the cost of the new equipment over time, balancing the impact on earnings.

Conclusion

  • Free cash flow is the term used to describe a company's ability to repay its debts while also providing dividends and interest to investors.
  • Free cash flow can be used by management and investors to assess a company's financial standing.
  • FCF reconciles net income by offsetting non-cash expenses, adjustments to working capital, and capital expenditures.
  • Free cash flow analysis can be used as an additional technique to check for problems before they show up on the income statement.
  • A company's share performance may trend downward, thus a good free cash flow does not always signal strong stock movements.
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