Free cash flow is most commonly defined as operating cash flow minus capital expenditures. A more stringent definition includes dividend outlays as a capital expenditure. Capital expenditures are considered necessary to maintain a company's competitive position and operating efficiency.
The calculation used to determine free cash flow is net income plus amortization and depreciation minus the change in working capital minus capital expenditures. Operating cash flow is calculated in the same way, though it omits capital expenditures.
Many analysts feel dividend outlays are just as important an expense as capital expenditures. The board of directors of a company may elect to reduce a dividend payment. However, this usually has a negative effect on stock price, as investors tend to sell holdings in companies that reduce dividends.
Free cash flow and operating cash flow are sometimes used to define a ratio that is useful when comparing competitors in the same or comparable industries.
Free cash flow is a measure of financial performance, similar to earnings, and its use is considered one of the non-Generally Accepted Accounting Principles (GAAP). It measures the cash flow available for distribution to all company securities holders. It can be envisioned as cash left after the financing of projects to maintain or expand the asset base.
Many analysts prefer free cash flow to earnings as a basis for evaluating a company's performance because free cash flow is more difficult to fabricate. In general terms, the higher a firm's free cash flow, the better the company is performing.
Operating cash flow, free cash flow and earnings are all important metrics when researching and evaluating a company that you are considering for investment. Booking a large sale has the effect of boosting earnings. However, if a company is not paid for that sale, cash flow is affected.
In other situations, a company may be very profitable on a cash-flow basis but have meager earnings if it is in capital-intensive industries, which require large fixed asset outlays. Accelerated depreciation of assets also creates a widened differential between cash flow and reported earnings.
Apple (AAPL) reported free cash flow of $64.12 billion in 2018, up 23.85% from the previous year. Apple reported operating cash flow of $77.43 billion, up 17.86% from 2017. Net income was reported to be $59.53 billion, representing an increase of 18.78%. On an annual basis, Apple has increased both its operating and free cash flow in eight of the past 10 years, with 2016 and 2017 being the only examples of declines.
Amazon (AMZN) reported free cash flow of $6.48 billion in 2017, down 33.26% from the previous year. Amazon reported operating cash flow of $18.43 billion in 2017, up 12.1% from 2016. Net income was reported to be $3.03 billion, representing an increase of 27.85%.
Companies with higher operating cash flow, free cash flow and earnings tend to have higher appreciation in the value of their shares. Some analysts also study free cash flow, operating cash flow and earnings on a per share basis. This allows for dilution of cash flow or earnings if a company issues more shares to raise capital and through employee compensation packages.