Free cash flow is something you need to understand if you want to know how much cash you have on hand to grow your business or pay off debt.
For small business owners, the term “free cash flow” may be new. But it’s an important sign of how well your business is doing financially, and it can be very important if you’re looking for partners or investors. Because of this, smart business owners who want to grow their companies must fully grasp the concept of free cash flow.
What is Free Cash Flow?
Free Cash Flow is the money a business has left over after paying its bills and making investments to grow. It’s basically the money that a business can use to buy back its own stock, pay dividends to owners, or start new projects.
Think of it as the money you have left over after paying your bills and rent. You can have fun with that money by taking a trip or saving up for a new car. This is similar to how a company’s free cash flow is the money it can use to do things that are good for the business or its shareholders.
Formula for Free Cash Flow
Free Cash Flow (FCF) can be calculated using the following formula:
FCF = Operating Cash Flow – Capital Expenditures
- Operating Cash Flow is the cash generated from a company’s core business operations.
- Capital Expenditures are the investments a company makes in long-term assets, such as property, plants, and equipment.
What is an Example of Free Cash Flow?
Zomato, a well-known platform for restaurant discovery and food delivery, gets its revenue primarily from advertising and commissions on food orders. If  Zomato’s operating cash flow (revenue minus expenses) is $100 million and it invests $30 million in new restaurants, delivery vehicles, and technology, its free cash flow would be $70 million ($100 million – $30 million).
Many kinds of purposes could be achieved with this $70 million, including:
- Dividend payments to shareholders: Zomato may allocate a portion of this capital to its investors as compensation for their investment.
- Buyback of shares: Zomato has the option to acquire its own shares, which could potentially increase the value of the remaining shares and decrease the number of outstanding shares.
- Investing in new projects: Zomato could utilize this capital to broaden its operations, including creating new features or entering new markets.
- Zomato could utilize this cash to settle its current debt, thus improving its financial well-being and reducing its financial obligations.
Types of Free Cash Flow
There are two major types of free cash flow:
- Operating Free Cash Flow (OFCF): This metric tracks the cash earned by a company’s main business operations. You calculate it by subtracting capital expenditures from operating cash flow. OFCF is frequently used to assess a company’s financial health and ability to continue operations while generating profits.
- Free Cash Flow to Equity (FCFE): This metric calculates the cash available to a company’s equity stockholders after deducting debt commitments and capital expenditures. It is calculated by removing net capital expenditures and interest payments from operating cash flow. FCFE is used to determine the cash available for dividends, share buybacks, and other shareholder-friendly actions.
What Free Cash Flow Can Tell You?
Free Cash Flow can provide valuable information about a company’s financial health and future prospects. By analyzing a company’s free cash flow, investors can:
- Assess financial strength: Positive free cash flow means that a company is generating more cash than it is spending, which can suggest financial stability and growth possibilities.
- Evaluate investment opportunities: Companies with high free cash flow may be able to invest in new projects, enter new markets, or purchase other businesses.
- Determine dividend potential: Companies with enough of free cash flow may be able to pay dividends to shareholders, resulting in a return on investment.
- Monitor debt repayment: Free cash flow can be utilized to pay off debt, increasing a company’s financial flexibility and lowering its risk.
- Comparing a company’s free cash flow to that of its competitors allows investors to evaluate its relative financial performance and competitive position.
Advantages and Disadvantages of Free Cash Flow
| Advantage | Disadvantage |
|---|---|
| Financial Health Indicator: Shows a company’s ability to generate cash and meet obligations. | Can be Manipulated: Aggressive accounting practices can inflate FCF. |
| Investment Potential: Indicates a company’s ability to reinvest in growth or acquire other businesses. | Can be Negative: Negative FCF may signal financial difficulties or excessive capital expenditures. |
| Dividend Payout: This suggests a company’s capacity to pay dividends to shareholders. | Non-Cash Items May Have An Impact: Depreciation and amortization may have an impact on FCF without affecting actual cash flow. |
| Debt Repayment: Demonstrates a company’s ability to reduce debt and improve financial flexibility. | Can Vary Over Time: FCF can fluctuate due to economic conditions, industry trends, and company-specific factors. |
| Valuation Tool: Used in valuation models to assess a company’s intrinsic value. | May Not Reflect True Cash Flow: Non-operating cash flows and working capital changes can affect actual cash availability. |
Differences Between Free Cash Flow and Net Income?
| Feature | Free Cash Flow | Net Income |
|---|---|---|
| Definition | Cash generated by a company’s operations after accounting for capital expenditures. | Profit earned by a company after deducting all expenses from revenue. |
| Focus | Cash flow | Profitability |
| Calculation | Operating Cash Flow – Capital Expenditures | Revenue – Expenses |
| Non-Cash Items | Includes non-cash items like depreciation and amortization. | Excludes non-cash items. |
| Investment and Dividend Payouts | Directly related to a company’s ability to invest in growth or pay dividends. | Indirectly related, as higher net income may lead to increased cash flow. |
| Financial Health Indicator | Provides a more accurate picture of a company’s financial health, especially for capital-intensive businesses. | Can be misleading for companies with significant non-cash expenses. |
What Does It Mean When Free Cash Flow is Negative?
A negative free cash flow indicates that a corporation spends more money on capital expenditures than it generates from operations. This can be reason for concern because it suggests that the company relies on external finance, such as debt or stock, to fund its expansion or operations.
While a negative free cash flow is not always a bad sign, it is crucial to look at the underlying reasons for the negative figure. If a corporation invests extensively in growth projects that are likely to generate significant returns in the future, a temporary negative free cash flow may be acceptable. However, if the negative cash flow is the result of reducing sales, growing costs, or mismanagement, it may indicate financial difficulties.
What is the Price to Free Cash Flow Ratio?
The Price to Free Cash Flow (P/FCF) ratio is a valuation tool that compares a company’s share price to its free cash flow. It is calculated by dividing the market price per share by the free cash flow per share.
A lower P/FCF ratio typically implies that a company’s stock is undervalued in relation to its potential to generate cash flow. On the other hand, a greater P/FCF ratio indicates that the company may be overvalued. When assessing the P/FCF ratio, other aspects to examine are the company’s growth forecasts, industry trends, and overall financial health.
What is Free Cash Flow Yield?
Free Cash Flow Yield is a financial statistic that compares a company’s free cash flow to its market capitalization. It is determined by dividing the company’s free cash flow per share by its stock price.
A greater free cash flow yield shows that a company is earning more cash relative to its market value, which is a good indicator for shareholders. This indicates that the corporation is efficient at earning cash and may be able to pay dividends, decrease debt, or reinvest in the business.
What is Free Cash Flow to Equity?
Free Cash Flow to Equity (FCFE) is the amount of cash available to a company’s equity stockholders after reducing debt and capital expenditures. It is simply the cash left over after a firm has paid its operational expenditures, invested in its growth, and fulfilled its debt commitments.
The FCFE is determined by reducing net capital expenditures and interest payments from operating cash flows. It’s a valuable statistic for investors looking to evaluate the cash available for dividends, share buybacks, and other shareholder-friendly operations.
