What is Free Cash Flow? Definition and Formula

Free cash flow (FCF) is one of the most important metrics used to assess how much cash flow a company is generating. It is widely used in investments, and in business. FCF is often used as the best metric to assess a company’s profitability because it is the cash available to the company to reward shareholders through buybacks and dividends and repay its debts. Although some investors use earnings as their main metric to evaluate a company’s profitability, FCF seems to be a more accurate measure. This is because it includes changes in working capital, and capital expenditures (CAPEX). At the same time, it does not include non-cash expenses that are reflected on the income statement. 

The meaning of free cash flow

The term free cash flow, also designated by the abbreviation FCF, represents the cash left over after subtracting money used for operations and capital expenditures. FCF excludes non-cash expenses on the income statement. Therefore it is a measure of profitability that includes expenditures on capital and assets. As well as the changes in the amount of working capital noted on the balance sheet. This exclusion extends to interest payments. 

When analysts are evaluating a company’s ability to generate cash flow, they will use different FCF models. Comparing free cash flow to equity, or market cap, or enterprise value. This is in order to determine the profitability of a particular investment as well as account for dilution on the value of a company’s stock. 

In summary, FCF is the amount of money available to a company to pay back its debts and potentially award dividends to investors. FCF is one of the most important metrics, often used as an investment analysis tool. Because it can help investors understand the financial dynamics of a company. 

FCF allows investors to understand how much cash flow the business is actually generating that can be used to reward shareholders. It can also reveal potentially deep-seated problems that are not readily apparent from the income statement. 

The Free Cash Flow (FCF) Formula

There are a few ways to calculate free cash flow:

Based on operating cash flow

Free Cash Flow (FCF) = Operating Cash Flow (OCF) – Capital Expenditures (CAPEX)

Based on net income

Free Cash Flow = Net Income + Depreciation/Amortization – Changes in Working Capital – CAPEX

How to calculate free cash flow yield

A common way to use free cash flow when you are analyzing stocks is to use FCF yield. This metric allows investors to compare the FCF generated by the company, with its current market cap. Giving them an accurate picture of how much FCF a particular investment will generate based on its cost.

FCF yield can be calculated using two formulas. You can either calculate it based on the FCF of the entire business, or you can calculate it on a per-share basis. The results will be a percentage of FCF generated, based on your initial investment.

Formula

Free Cash Flow Yield = Free Cash Flow/Market cap

Free Cash Flow Yield = Free Cash Flow Per Share/Share Price

Understanding FCF

Understanding a company’s FCF metric can help investors determine many things about the stock in question. It is one of the most accurate metrics to assess a company’s ability to generate cash flow. However, there are some downfalls of solely using this metric to analyze investments.

How can FCF in isolation give investors the wrong impression of a company? 

FCF can often be misleading because it fails to consider a possible increase in capital expenditures. For this reason, it is important for investors to take into consideration the management’s expected future capital expenditures. For this reason, a decrease in a company’s FCF doesn’t always signal that it is in distress. 

FCF is often much lower when a company embarks upon an expansion, acquisition, or engages in research and development. This is why it is critical that investors use a holistic evaluation process when examining a firm’s balance sheet. There is also the age of the firm in question to consider. Older companies, on the whole, tend to exhibit much more stable FCF than younger firms. 

Further, investors need to consider the industry that the company operates within as well. Some companies need to make heavy expenditures into capital equipment and so on to remain competitive while others are more asset-light comparatively. Being able to analyze FCF within the context of the company and industry in question will be an important factor to assess its FCF.

Conclusion

Well-known investors often use FCF as the main metric to assess a company’s ability to generate cash. This allows them to calculate how much the company will be able to reward its shareholders. It is also important to take into consideration changes in working capital that might happen due to external factors, and momentary increases in CAPEX.

FCF remains the best metric for evaluating any investment because it accurately displays how much money the company generates after paying all its necessary expenses to maintain the business running. It is the most important metric to understand how to value a stock.

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