What is Free Cash Flow (FCF)?
Published by Sharekhan Education | December 17, 2020
What is Free Cash Flow (FCF)?
Free cash flow represents the cash that a company can generate after laying out the money required to maintain or expand its asset base. Free cash flow is an important parameter to track because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it is tough to make acquisitions, pay dividends, and reduce debt.
FCF calculation is as follows:
Net Income
+ Non Cash expense (E.g. Depreciation/Amortization)
– Changes in Working Capital
– Capital Expenditures
———————————————
= Free Cash Flow
It also can be calculated by taking operating cash flow and subtracting capital expenditures.
Cash flow is the equivalent of savings for a household. Household’s financial health will suffer a lot in the future if we cannot save or stay within our budgeted expenses. We would have to borrow from relatives, banks, and others to meet our requirements. Debt pressure increases the bankruptcy risk and leads to stress in our lives.
The scenario is the same for companies as well. If a company does not have positive free cash flow, it will spend beyond its means. Such a company would have to raise funds from additional sources like debt or equity dilution to meet its requirements. The funds, if raised from debt, would decrease profitability by interest expense. If raised through equity, then it would lead to dilution of the stake of existing shareholders. If the companies continuously keep raising debt or equity to meet their cash flow requirements, it becomes less attractive for long-term investors. The companies that can meet their fund requirements from their operating cash flows are more attractive to investors.
It is important to note that negative free cash flow is not necessarily a bad thing. If free cash flow is negative, it can be possible that a company is making large investments. If these investments earn a high return, the strategy can potentially pay off in the long run. However, an investor needs to make sure that the negative free cash flow is not due to working capital crunch.
Earnings often can be clouded by accounting gimmicks, but it is tougher to fake cash flow. For this reason, seasoned investors believe that FCF gives a much clearer view of a company’s ability to grow and generate cash (and thus profits). FCF is the ultimate measure for investing in any company.
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