Free Cash Flow – Definition

Cite this article as:"Free Cash Flow – Definition," in The Business Professor, updated September 17, 2019, last accessed August 11, 2020, https://thebusinessprofessor.com/lesson/free-cash-flow-definition/.

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Free Cash Flow Definition

Free cash flow refers to the cash that a firm has post its cash outflow transactions which it uses for carrying its business activities and sustaining its long-term assets. Free cash flow is not the same as earnings or net income. It ascertains profits excluding the non-cash or non-liquid expenses recorded in the income statement, and includes expenses related to equipment and assets, and variations in working capital.

Free cash flow doesn’t include interest payments. For ascertaining the estimated performance of a company regarding various capital structures, investment bankers and financial analysts use different types of free cash flow such as free cash flow for the firm and free cash flow to equity. These free cash flow are balanced for interest payments and loans.

A Little More on What is Free Cash Flow

The evaluation of free cash flow is made on the basis of per share so as to analysis the dilution effect.

All stockholders, preferred shareholders, and creditors of the company receive cash flow in the form of free cash flow. There are many investors who choose free cash flow or free cash flow per share instead of earnings and earnings per share for determining the financial position of a company. Though FCF accounts are related to property, equipment or plant related investments, it can show inconsistency over a period of time.

Let’s say, the earnings before depreciation, amortization, interest, and taxes (EBITDA) of a company are $1,000,000 for a specific time period. Also, there were no changes made in the working capital of the company. However, they purchased a machinery of $800,000 at the year end. The costs related to this new machine will be allocated for a time period in the income statement, which balances the effect on earnings.

However, since free cash flow represents new machinery in one go, the company will report free cash flow of $200,000, which is the difference between EBITDA and machinery, on EBITDA of $1,000,000. In case, the company makes no additional purchases for machinery, and other things remain constant, the value of FCF will be equivalent to EBITDA in the coming year. In such case, an investor will require to know the reason of free cash flow falling so steadily one year just to get back to prior levels, and if it is likely that such change would persist ahead.

Free Cash Flow in Company Analysis

Since free cash flow exhibits fluctuations in working capital, it can offer important information about the company’s goodwill as well as its financial position. For instance, if accounts payable fall, it would signify that vendors require steadier payments from their customers/company. In case, accounts receivables decrease, it signifies that the company is able to collect quick payments from its customers. If there is an increase in inventory, it would signify that the firm is holding a stock of items that have not been sold yet. When the company considers working capital in determining its profits, it gives an insight that its income statement doesn’t include.

For instance, the annual net income of a company is $50,000,000 for the last 10 years. In spite of such consistency, there can be cases when free cash flow of the company has been falling for the last 2 years. The culprits are increase in inventory, delay in accounts receivables, and increase in accounts payable. This signifies poor financial position of the firm that one could not have estimated by only studying the income statement.

Free cash flow also gives an idea to prospective shareholders of the firm in knowing the extent of dividends or interest the firm would be able to pay. In case, the free cash flow of the company excludes the debt payments, it will inform the lender about the quality of cash flows available for more debts. Also, shareholders consider FCF-interest payments in knowing how consistent the prospective dividends would be.

Free Cash Flow Calculations

Free cash flow considers cash flows from operating activities (given in the cash flow statement) as it includes already adjusted income for interest payments, changes that the working capital encountered, and non-cash expenses.

Besides income statement, and balance sheet, the company can also use cash flow statement for arriving at free cash flow. For instance, in the absence of EBIT (earnings before income and tax), an investor can use the following approach for getting the right calculation.

Free cash flow doesn’t require disclosing financial information just like line items in the company’s financial books. FCF offers verification of the profitability reports of the company. Even if it is good to do so, every investor doesn’t have the strong knowledge, or are not interested in instilling their time in making such manual calculations.

How to define Good Free Cash Flow

Reputed websites like Investopedia offers insights of free cash flow for the majority of the public organizations. However, the main concern is to find out what a good FCF looks like. There can be cases when firm with great or positive FCF show unfavorable stock movements. Also, there can be times when firm with positive FCFs can showcase favorable stock trends.

The FCF trends can simplify your observation. As per technical researchers, we can emphasize on patterns associated with the primary performance instead of the absolute figures of free cash flow, income, or sales revenues. In case, the prices of stock are a function of the related fundamentals, then there should be a positive correlation established between the free cash flow and average patterns of stock prices.

It is wise to use the consistency of free cash flow for ascertaining the levels of risk. If FCF has been stable for the last 4-5 years, then there would be less possibility of bullish stock patterns getting disrupted ahead. On the other side, declining FCF patterns, particularly the ones that are quite distinct in comparison to sales patterns, and earnings, are a sign of negative price movement.

Such method doesn’t include the exact value of free cash flow for emphasizing on FCF slope and its link with the price performance.

What would you infer about the probable trend in stock price with separate fundamental performance?

Considering such trends or patterns, an investor would get a hint about the issues that are not included in the firm’s revenues and earnings per share. What could be the reasons behind these issues?

Investing in growth

An organization might experience such diverging patterns because management is focusing more on investments in plant, property, and equipment for expanding its operations. Earlier, an investor might identify that this is possible, by seeing if CAPEX was getting bigger in 2016-2018. If the sum of FCF and CAPEX were still showing an upward movement, it would be feasible for the value of a stock.

Stockpiling inventory

In the years 2015 and 2016, the Deckers Outdoors Corp, popular for their UGG boots, made sales of around 3% with the inventory increasing by over 26%. This led to a decline in free cash flow in spite of the increasing revenues. This data would help the investor in knowing if DECK would succeed in coping up with their inventory problems or if their product, that is UGG boots, were no more in fashion, prior to investing with additional risks.

Credit problems

A shift in the accounts receivables, or the accounts payables, or inventory can cause a change in the working capital of a company. There will be an increase in the accounts receivables of a firm when the company creates more lenient payment methods for their customers so as to increase sales. This will create a negative or unfavorable adjustment to free cash flow. Also, the firm would experience a negative accounts payable when the vendors don’t want to offer credit, and want steadier payments instead.

Several solar organizations were facing the same credit problems from the year 2009 to 2015. There was seen an increase in sales and income of these firms with more lenient payment conditions made for clients. Since the industry was well aware of this issue, suppliers resisted in extending terms and asked solar organizations for making faster payments. In this case, it was prominent to see the divergence between the fundamental patterns in free cash flow. However, it was not sufficient to observe just the income statement.

Summary

Free cash flow balances net income of a company by making adjustments for non-cash expenses, variations in working capital or short-term obligations, and capital expenditures. It tends to be more inconsistent as compared to net income but can identify issues in the fundamentals before they appear on the income statement.

References for “Free Cash Flow – FCF”

https://corporatefinanceinstitute.com/resources/knowledge/…/fcf-formula-free-cash-flow/

https://www.investopedia.com › Investing › Financial Analysis

https://www.wallstreetmojo.com › Valuation › Discounted Cash Flow

https://en.wikipedia.org/wiki/Free_cash_flow

https://investinganswers.com/financial-dictionary/financial…/free-cash-flow-1000

https://www.myaccountingcourse.com › Financial Ratio Analysis

https://www.divestopedia.com/definition/835/free-cash-flow-fcf

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