Free Cash Flow-to-Sales

What Is Free Cash Flow-to-Sales?

Free cash flow-to-sales is a performance ratio that measures operating cash flows after the deduction of capital expenditures relative to sales. Free cash flows (FCF) is an important metric in assessing a company's financial condition and determining its intrinsic valuation. FCF-to-sales is tracked over time and compared with competitors to provide further information internally to management and outside investors.

Understanding Free Cash Flow-to-Sales

Though there may be slight variations in the way companies calculate free cash flows, FCF is generally calculated as operating cash flows (OCF) less capital expenditures. Capital expenditures are required each year to maintain an asset base at a very minimum, and to lay a foundation for future growth. When OCF exceeds this type of reinvestment into the business, the company is generating FCF. 

FCF is key for the company and its shareholders because this cash can be utilized to pay higher dividends, repurchase shares to reduce shares outstanding (thus leading to higher earnings per share (EPS), all else equal), or acquire another company to enhance growth prospects for the firm. How a company handles FCF is part of its capital allocation policy.

Special Considerations

Having FCF, of course, is desirable, but the amount should be placed in context. This is how the free cash flow-to-sales ratio is useful. A higher FCF-to-sales is better than a lower one, as it indicates a greater capacity of a company to turn sales into cash.

If, for example, a company's FCF/sales have been declining, the management team can analyze the components of operating cash flow (OCF) and rethink capital expenditure levels in an effort to increase the ratio. If the company sees an improving trend but finds its ratio trailing the industry average, management will be encouraged to explore avenues to close the gap.

It should be noted that free cash flows-to-sales should be tracked over sufficient periods to account for short-term periods during which a company is making heavy investments for future growth. In other words, low or negative FCF-to-sales may not necessarily mean that a company is experiencing business challenges. Instead, it may indicate that it is in the middle of a period of significant capital investments to meet expected higher demand for its products in the future. The ratio could be suppressed for a year or two but then revert to the longer-term trendline.

Example of Free Cash Flow-to-Sales

Below is a historical example that shows the calculation of free cash flow-to-sales for Apple Inc. All of the figures listed below were obtained from Apple's fiscal year 10K annual report.

Fiscal Year 2019

Apple for the fiscal year 2019 generated revenue from sales of $260.2 billion, which is found at the top portion of the income statement. The company generated $69.4 billion in operating cash flow, which is found within the "operating activities" section of the cash flow statement (CFS) labeled "cash generated by operating activities".

Apple spent $10.49 billion on capital expenditures, which is found within the "investing activities" section of the CFS labeled "payments for acquisition of property, plant, and equipment".

Below is a breakdown of the numbers and the calculation of Apple's 2019 FCF-to-Sales:

• Sales revenue: $260.2 billion
• Operating cash flow: $69.4 billion
• Capital expenditures: $10.49 billion

First, calculate free cash flow as follows:

• Free cash flow: $58.91 billion, calculated as $69.4 billion (operating cash flow) - $10.49 billion (capital expenditures)

Calculation of FCF-to-Sales:

• Free cash flow to sales: 22.6% or .226 calculated as $58.91 billion (free cash flow) / $260.2 billion (sales). The result of .226 can be multiplied by 100 to convert it to a percentage.

In other words, in 2019, Apple generated 22.6% free cash flow for every dollar of revenue generated from the sale of its products and services. The FCF-to-sales figure doesn't provide much information unless we compare the number to a prior period, as shown below.

Fiscal Year 2018

Below are Apple's numbers for the fiscal year 2018 and the calculation of FCF-to-Sales:

• Sales revenue: $265.6 billion
• Operating cash flow: $77.4 billion
• Capital expenditures: $13.3 billion

First, calculate free cash flow as follows:

• Free cash flow: $64.1 billion, calculated as $77.4 billion (operating cash flow) - $13.3 billion (capital expenditures)

Calculation of FCF-to-Sales:

• Free cash flow to sales: 24.1% or .241 calculated as $64.1 billion (free cash flow) / $265.6 billion (sales). The result of .241 can be multiplied by 100 to convert it to a percentage.

In other words, in 2018, 24.1% of Apple's sales were converted to free cash flow, which was higher than the 22.6% FCF-to-sales in 2019. The difference in FCF-to-sales was due, in part, to Apple generating $8 billion more in operating cash flow in 2018 versus 2019.

It's important to compare these results over multiple years to determine if there's a trend while also calculating the FCF-to-sales for Apple's competitors to gauge its performance versus the industry. As with any financial ratio, no single metric provides an all-inclusive analysis of a company's financial performance. As a result, it's best to use multiple financial ratios when conducting a thorough review of a company.