Free cash flow (FCF) is a reliable financial metric if you want to help your clients understand the real cash-generating power of a business. It can offer a clear picture of how much cash is truly available after a company covers its operating expenses and invests in assets.
In this article, Wealth Professional Canada will explore the concept of FCF, how to calculate it, and how FCF differs from profit. We will also talk about some of its limitations. Want to learn how to interpret FCF on financial statements? Read on for more.
Free cash flow is a measure that reveals how much money a business generates over a specific period, after accounting for all the costs required to maintain and grow its operations. It focuses on the actual cash left over once a company pays its bills and invests in its future. This metric is relevant for larger and publicly traded companies, but it can also provide valuable context for smaller businesses.
For financial advisors, understanding FCF is vital when assessing a company’s capacity to pay dividends or reduce debt. It is equally important for evaluating said company’s ability to reinvest in its own growth and operations.
The data needed to calculate FCF is available in the cash flow statement and income statement. However, it’s not a line item on financial statements.
FCF can also be a critical part of fundamental analysis because it shows how much cash a company truly generates after expenses and investments. This helps investors assess the company’s real financial health and long-term value.
There is no single, universally accepted formula for calculating FCF. Several methods exist, and the choice often depends on the available data and the specific needs of the analysis.
However, all approaches aim to determine how much cash remains after a company funds its operations and capital expenditures. Let's look at one formula for FCF:
Net cash from operating activities represents the cash generated by the company’s core business operations. This figure is found in the operating activities section of the cash flow statement.
Capital expenditures refer to cash spent on acquiring or upgrading physical assets such as:
This amount is found in the investing activities section of the cash flow statement.
Alternative calculation method
Another approach to calculating FCF uses figures from both the income statement and the balance sheet:
This formula starts with net income and adds back non-cash expenses such as depreciation and amortization, as well as interest and taxes. It then subtracts changes in non-cash working capital and capital asset acquisitions.
Determining what constitutes a good FCF depends on several factors such as the company’s industry and growth stage. Its capital requirements should also be considered. As such, FCF should always be interpreted in context.
Positive versus negative
A positive FCF could mean that a company generated more cash than it needed to fund its operations and capital investments. This surplus cash can be used to:
A consistently positive FCF is generally a sign of financial strength and operational efficiency. As for a negative FCF, this could indicate that a company spent more cash than it generated during the period. Still, this situation is not always a cause for concern.
For instance, a company might have made significant investments in new equipment or technology to support future growth. In such cases, negative FCF can be a temporary result of strategic expansion.
However, persistent negative FCF over several periods might signal underlying financial challenges. If a company consistently spends more than it generates, it might face difficulties meeting its obligations or funding future growth.
Industry-specific benchmarks
Long-term trends
Short-term fluctuations in FCF are common, especially when companies make large, infrequent investments. As a financial advisor, it’s beneficial to focus more on long-term trends rather than isolated periods.
A company that’s consistent in delivering positive FCF over several years is generally in a stronger financial position than one with erratic or negative FCF.
Short answer: no. FCF and profit are related but distinct concepts. Let’s compare them further below:
Profit
Profit, also called net income, is the amount left after all expenses are deducted from revenue. It includes non-cash items such as depreciation and amortization, as well as gains or losses from asset sales and other accounting adjustments.
Watch this video to know more about profit and how it’s calculated:
Net income is commonly used to calculate earnings per share (EPS) and price-to-earnings (P/E) ratios.
Free cash flow
FCF focuses solely on actual cash transactions. It excludes non-cash expenses and includes capital expenditures and changes in working capital. FCF can also provide a clear view of how much cash is available to fund dividends or repay debt.
To illustrate, a company might report positive net income but have negative FCF if it makes large-scale capital investments or if cash is tied up in inventory. Conversely, a company might have positive FCF even when reporting a net loss, especially if non-cash expenses are high.
While FCF is a valuable metric, it has several limitations that financial advisors should consider when analyzing companies:
Calculating FCF requires gathering data from multiple sections of a company’s financial statements. The cash flow statement is the primary source, but the income statement and balance sheet might also provide relevant information.
Cash flow statement
The cash flow statement is divided into three sections:
Income statement
The income statement provides figures for:
These items can be used in alternative FCF calculations.
Balance sheet
The balance sheet shows changes in working capital, such as:
These changes are important for calculating FCF using the alternative method.
FCF provides a practical measure of a company’s ability to generate cash after covering all necessary expenses and investments. While it has limitations and requires careful analysis, FCF can still be a reliable indicator of a company’s financial strength, especially when used with other elements.
This metric can also aid in revealing potential risks that might not be visible through profit alone. When you’re knowledgeable about free cash flow, you can help your clients realize the cash-generating prowess of businesses. In turn, they can make better investment choices that align with their goals.
Want to read more about free cash flow and other key financial metrics? Feel free to explore our Investor Resources page.
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