What Is Free Cash Flow-To-Sales?
Free cash flow-to-sales is a performance ratio that measures operating cash flows after 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/sales is tracked over time and compared with peers 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, in turn, 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 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.
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. Obviously, higher FCF/sales is better than lower, as it indicates a greater capacity of a company to turn sales into what really matters — cash. But trend observation and peer comparison provide clues about its competitiveness in the market. If, for example, the company notices that FCF/sales has been on the decline, it will analyze the components of OCF and rethink capital expenditure levels in an effort to increase the ratio. If the company sees an improving trend but finds that its ratio is 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/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.