Cash Flow Statements are an important part of the financial statements of a company. It showcases the liquidity position of the company and various avenues where the organization receives its cash resources and spends the same. Apart from cash flows, business organisations also need to understand the concept of free cash flows to understand the true cash position of the business. The meaning of free cash flows and related details are given below.
What is the meaning of free cash flow?
Free cash flow (FCF) is a financial metric that measures the final cash actually generated by a company. It is measured to be the resultant amount available to be distributed to its investors, both equity and debt holders, and is calculated after considering all the capital expenditures and operating expenses of the organisation. Such cash can be used by the company to invest in different growth opportunities, reduction of debt levels, pay dividends, or repurchase shares.
FCF is an essential metric for investors and analysts to determine a company’s financial health and growth potential. A company that generates positive free cash flow can reinvest in its business and use it to meet its various needs. On the other hand, a company that generates negative free cash flow may not be usually favoured by institutional investors as the company would have to borrow more money to fund its operations or investments. This can significantly increase the risk of default for investors and lenders.
What is the formula to calculate free cash flow?
The formula to calculate free cash flow (FCF) is:
FCF = Operating Cash Flow – Capital Expenditures
The Operating Cash Flow (OCF) represents the cash generated by a company’s operations while the Capital Expenditures (Capex) are the investments made by the business in property, plant, and equipment.
Additionally, other formulas that can be used to calculate free cash flow are
- Calculating FCF using sales revenues
Free cash flow = Sales revenue – Operating costs and taxes – Investments in operating capital
- Calculating FCF using Net operating profits
Free cash flow = Net operating profit after taxes – Net investment in operating capital
What are the pros and cons of free cash flow?
Free cash flow (FCF) is a useful financial metric that can help investors and analysts evaluate a company’s financial health and growth potential. However, there are both pros and cons associated with using FCF to make investment decisions. Here are some of the key advantages and disadvantages of using free cash flow:
Some of the key uses or benefits of using free cash flows are highlighted below.
- True measure of cash generation capacity
By using FCF, the business entity can provide a more accurate measure of a company’s cash generation capacity as compared to earnings. This can be as the latter can be influenced by non-cash items like depreciation and amortization. FCF provides a clearer picture of the company’s financial health by focusing on cash and its ability to meet its commitments like payment of dividends, reduction in debt levels, or investment in strategic growth opportunities.
- Measures earnings quality of the business
The calculation of FCF is crucial in understanding the quality of a company’s earnings. Investors can consider a negative FCF as a red flag if a company reports high net income but has a negative FCF. Such scenarios can be seen as a warning sign that the earnings of the company are not sustainable in the long run.
- Shows financial flexibility
Positive FCFs also give such companies the benefit of financial flexibility which can be used to invest in diverse growth opportunities. This can ultimately increase the shareholder’s value and accelerate long-term growth.
The key limitations or disadvantages of FCF include,
- Capital-intensive companies may have negative FCF
Capital-intensive companies require significant investments in capex. This expenditure is essential to maintain or grow their operations and can result in negative free cash flow even if the company is profitable. Such scenarios make it difficult to evaluate the true financial performance of companies based on FCF alone.
- Different views due to different accounting policies
Free cash flow is affected by the accounting policies of the company and can be different in recognizing revenue and expenses. Diverse accounting policies can make it difficult to compare FCF between companies in the same industry.
- Varied FCF due to fluctuations in working capital
Working capital requirements can vary from time to time and it can affect the calculation of free cash flows. This can make it difficult for analysts to interpret the FCFs over short time periods and can lead to inaccurate decisions.
FCF is an important measure of a business’s real earning potential and its ability to stay afloat. Therefore, this analysis is a key point of consideration for investors and lenders while reviewing any company seeking funds. FCF should be coupled with other financial metrics to obtain a clear picture of the company’s financial position in comparison to its past performance as well as that of its peers in the industry.
There are two types of FCF namely Unlevered FCF and Levered FCF. The former measures the cash generated by a company’s operations without taking into account the effects of its capital structure, ie., without considering before accounting for interest payments on debt or tax deductions from interest payments. The latter on the other hand measures the cash generated by a company’s operations after accounting for the effects of its capital structure which includes interest payments on debt and tax deductions from interest payments.
The several users of the FCF include investors, analysts, management, creditors, and market regulators
The potential uses of FCF include valuation of the business, ascertaining its creditworthiness and financial health, evaluating the performance of the company over a period of time, and effective capital allocation.
There are multiple formulas to calculate FCF as the disclosures of every company differ according to their business policies and accounting policies. FCF is therefore calculated based on the available information.