Free Cash Flow is a financial metric used by investors to gauge the overall profitability of a company. Free cash flow is calculated by taking net income and subtracting from it any capital expenditures. This keeps the number as close to “cash in your pocket” as possible and helps you identify whether or not your company’s profits are being put back into the company or if they’re being used for other purposes such as paying down debt or even buying more assets (such as real estate).

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What is free cash flow?

Free cash flow is a measure of how much cash a company has available to pay its bills and invest in the future. It’s important because it provides an indication of how much cash the business has available to grow, pay dividends, or return to shareholders through stock buybacks.

Free cash flow is calculated by subtracting capital expenditures from operating cash flow (earnings before interest, taxes, depreciation, and amortization). It’s important to note that free cash flow does not include non-cash expenses such as depreciation and amortization (non-cash expenses are reported on the income statement).

What does FCF tell investors?

First and foremost, FCF is a measure of how much cash a company is generating. It separates operating activities from financing activities in order to show you how well your company is doing at producing positive cash flows from its operations.

Operating Cash Flow

Operating cash flow is a key metric used by investors and analysts to evaluate a company’s financial health. It represents the cash generated from the company’s operations, after accounting for any taxes and interest payments. Positive operating cash flow is a sign that a company is generating cash from its primary business activities and can reinvest that cash into the business or use it to pay down debt. On the other hand, negative operating cash flow may indicate that a company is not generating enough cash to support its operations and may need to rely on external financing.
To find the operating cash flow of a company, you can check the company’s cash flow statement. The formula for calculating operating cash flow is:


Operating Cash Flow = Net Income + Non-Cash Expenses - Changes in Working Capital


Net income is the company’s total revenue minus its total expenses, while non-cash expenses include items such as depreciation and amortization. Changes in working capital refer to changes in a company’s current assets and liabilities, such as accounts receivable and accounts payable.

Capital Expenditures

Capital expenditures represent the amount of money a company has spent on purchasing or improving fixed assets, such as equipment or property. These expenses are typically necessary to maintain or grow a company’s operations, and they can have a significant impact on a company’s financial performance.
To find the capital expenditures of a company, you can check the company’s annual report or financial statements. The formula for calculating capital expenditures is:


Capital Expenditures = Ending PP&E – Beginning PP&E + Depreciation


PP&E stands for property, plant, and equipment, and it represents the fixed assets a company owns. Depreciation is the amount of the cost of an asset that is allocated to each period of its useful life. By subtracting the beginning PP&E from the ending PP&E and adding depreciation, you can calculate the total amount of capital expenditures a company has made during a period.

Free Cash Flow

Free cash flow is a measure of a company’s financial health that represents the amount of cash a company generates after accounting for capital expenditures. Positive free cash flow is a sign that a company is generating enough cash to reinvest in the business, pay dividends to shareholders, or pay down debt. On the other hand, negative free cash flow may indicate that a company is struggling to generate enough cash to cover its expenses and investments.


To calculate free cash flow, you can use the following formula:


Free Cash Flow = Operating Cash Flow - Capital Expenditures


By subtracting capital expenditures from operating cash flow, you can determine the amount of cash a company has available to use for other purposes. Free cash flow is a key metric used by investors and analysts to evaluate a company’s financial health and its ability to generate cash over time. However, it’s important to remember that free cash flow is just one of many metrics that should be considered when evaluating a company’s financial performance.

Main reasons why a company may be increasing its FCF

There are several reasons why a company may be increasing its FCF. Among them:

  • An increase in profit margins, which means more money is left over after all costs have been paid out
  • A decrease in debt obligations
  • An increase in cash from operations (generally because of higher revenues)
  • A decrease in capital expenditures (costs incurred to maintain or improve a company’s physical assets)
  • A decrease in working capital (current assets minus current liabilities), as well as any other items that can be classified as reductions to the current expenditure category: receipts for sales made but not yet collected; accounts payable owed by suppliers who haven’t yet delivered their products and services; accounts receivable owed by customers who bought goods or services they haven’t yet paid for

How to use FCF for comparing companies?

You can use FCF to compare companies by comparing their FCF with the industry and with competitors. You can also compare companies with the market by looking at their earnings yield (EBIT / Market Cap).

Let’s look at an example of each:

  • Comparing FCF between companies lets you see how a company is growing compared to its peers in the industry. If one company has higher growth than its peers, it is probably doing something right!
  • Comparing EBITDA / Market Cap lets you see which companies are trading at a cheaper price-to-earnings ratio than others in the market. This might help identify potential winners over time based on valuation alone!

Free cash flow yield as a financial ratio

Free cash flow yield is a measure of a company’s ability to generate cash. It is calculated by dividing the free cash flow per share (FCFPS) by the share price.

  • FCFPS = Free cash flow from operations
  • Share Price = Stock Price / Number of Shares

How to calculate free cash flow? Real examples

Free cash flow is the amount of money a company has left over after it covers all its operating expenses and capital expenditures. It can be calculated by subtracting the sum of capital expenditures, depreciation, and amortization from net income. A positive free cash flow means that a company is generating more cash than its spending, while a negative FCF indicates an overall loss in cash. Free cash flow yield (FCF Yield) refers to how much-annualized dividend per share you’d receive if your investment were paid out as a dividend yield (i.e., in one lump sum).

Cash flow from operations (CFO), also known as operating cash flow, measures the amount of money generated from day-to-day operations without factoring in non-recurring sources of funds such as debt financing or equity issuance/repurchases.

FAQ

How do you calculate free cash flow?

Free cash flow = sales revenue – (operating costs + taxes) – required investments in operating capital.

Why is free cash flow important?

Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value.

What is a good FCF?

In general, especially when researching dividend stocks, yields above 4% would be acceptable for further research. Yields above 7% would be considered of high rank.