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What is 'Free Cash Flow - FCF'

Free cash flow (FCF) is a measure of a company's financial performance, calculated as operating cash flow minus capital expenditures. FCF represents the cash that a company is able to generate after spending the money required to maintain or expand its asset base. FCF is important because it allows a company to pursue opportunities that enhance shareholder value.

BREAKING DOWN 'Free Cash Flow - FCF'

FCF is an assessment of the amount of cash a company generates after accounting for all capital expenditures, such as buildings or property, plant and equipment. The excess cash is used to expand production, develop new products, make acquisitions, pay dividends and reduce debt. Specifically, FCF is calculated as:

EBIT (1-tax rate) + (depreciation) + (amortization) - (change in net working capital) - (capital expenditure).

FCF in Company Analysis

Some believe that Wall Street focuses only on earnings while ignoring the real cash that a firm generates. Earnings can often be adjusted by various accounting practices, but it's tougher to fake cash flow. For this reason, some investors believe that FCF gives a much clearer view of a company's ability to generate cash and profits.

However, it is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run. FCF is also better indicator than the P/E ratio.

For more information, feel free to read Free Cash Flow Yield: The Best Fundamental Indicator and FCF: Free, But Not Always Easy.

An Example of FCF

FCF is a good indicator of the performance of a public company. Many investors base their investment decisions on the free cash generated by a company or its equity price to FCF ratio. For example, Southwest Airlines, a leading provider of domestic flights in the United States, is expected to realize large increases in its FCF, thus making it an attractive investment.

The company has been able to generate increased revenues and profits in 2014 and 2015, reaching a record $2.4 billion in profits for the fiscal year 2015. Additionally, its operating margin increased in 2015 to 20.1%, and is expected to produce even higher margins throughout 2016. Further, capital expenditures reached $2 billion in 2015 and are expected to cap out at $2.2 billion in 2017. This means that its FCF, which is a function of revenue growth and expenditures, is expected to double by the end of 2017.

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