Investing your money in the share market is often considered an excellent way to create a corpus. But when you select a company to invest in, you have to look at several factors. As such, you need to evaluate the company based on various parameters such as its ability to pay dividends, pay down debt, buy back stocks and also facilitate business growth. If a company can achieve these parameters, it almost certainly demonstrates its capacity to produce sufficient free cash flow or FCF. But what is free cash flow exactly, and why should you evaluate it while researching about a company? Here’s all you need to know about FCF.
Free Cash Flow – definition and meaning
Free cash flow is defined as the excess cash, which a company can generate after spending the necessary sums to support its operations. It is the amount that represents the surplus cash the company has after it has met its capital expenditure requirements and expanded its asset base. It primarily denotes the money available for all company investors, including shareholders.
Breaking down free cash flow meaning – how it differs from company earnings
To break down what exactly is ‘free’ about cash flow and how it is not the same as company earnings, you must understand that all income does not automatically equal to cash. Just because a company is “earning”, it does not necessarily mean that it is profitable and can spend its earnings. Companies can only spend ‘free cash’. As such, it is crucial to understand the difference in the terms ‘cash’ and ‘cash which you can take out of the business’; also known as ‘free cash flow’ or ‘cash from operations’ in accounting terms.
The cash from operations is the amount generated by business operations run by the company. However, as business owners know, it is not possible to take out all the cash from operations for business purposes, since companies may need some of it to keep running the operations, i.e. they need money for capital expenditure or CAPEX. Conversely, free cash flow refers to the cash the company can generate after spending the sums necessary to stay in business. It is the cash at the end of a financial year, after all the operating expenses, expenditures, investments and other such expenses are deducted. FCF is the amount that can be distributed to the company’s equity and debt stakeholders.
How to calculate free cash flow
Companies listed in the stock exchanges are not obligated to provide details about their free cash flow. As such, as an investor, there is no way to find out about a company’s FCF. Moreover, most companies do not even publish details about the FCF in their annual financial statements. That said, you can easily calculate the FCF, that too in two different ways. They are as under:
1. Through the company’s income statement and balance sheet
The first way to calculate a stock’s free cash flow is through its income statement and balance sheet. Fortunately, you can find these details in the annual financial statements of the company, and also on the websites of the companies offering the stocks. The first free cash flow formula is as under:
FCF = EBIT (1-tax rate) + (depreciation and amortisation) – (change in net working capital) – (capital expenditure)
2. Through the company’s cash flow statement
You can also calculate the free cash flow through the company’s regular cash flow statement, the details of which are also provided in the financial reports and on their website. The formula is as under
FCF = Cash flow from operating activities – capital expenditures
This approach is more popular, and as is evident, the free cash flow formula is quite simple too
The Significance of Free Cash Flow
Having explained free cash flow meaning and how to calculate it, let’s understand why it is significant.
As an investor, it is essential that you carefully check the free cash flow of the companies you’ve invested in since it is one of the most accurate ways to understand if the companies are profitable than their earnings. Remember, earnings only demonstrate the current profitability of a company, whereas the free cash flow signifies its future growth prospects. The free cash flow is the excess cash that enables companies to pursue various opportunities that lead to its growth, thereby enhancing the shareholder’s value as well. It mirrors the ease with which a company can grow and also pay dividends to its investors and shareholders. Companies can utilise the surplus cash to expand their operations and portfolio, develop new products and even acquire other businesses apart from paying dividends and reducing their debt.
Analysing free cash flow – what you need to know
Apart from knowing FCF meaning, you should also know how to analyse it. While studying about and calculating a company’s free cash flow, it is crucial to discover where and how the cash is coming in. A company may be generating money either from its earnings or through debts. If the cash flow has increased as a result of the earnings, you can consider it a good sign; however, if it has increased due to debts, it could be a red flag. Furthermore, if you notice that the cash flow of two companies is the same, you should not automatically assume that their prospects are similar. Remember, some industries are more capital intensive than others, which is why they may have higher capital expenditure. If your investigation shows the capital expenditure to be high, you should find out the reason for the same – whether it is expenses concerning growth or general expenditure. To be well-versed with these aspects and to analyse cash flow systems, you should read the quarterly or annual reports of the company.
Now that you know what is FCF, you must remember that it is an integral aspect of a business. It is something that you should consider as a potential stakeholder before you purchase stocks of a company. The company’s financial statements can also help you determine the investment duration – whether to stay invested for the long or short term. If you are someone who relies on dividends as a form of steady income, you need to ensure that the company you are investing in is profitable and able to generate free cash flow, dividends and other benefits that go with it.