What is Free Cash Flow?
Free cash flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital.
Interest payments are excluded from the generally accepted definition of free cash flow. Investment bankers and analysts who need to evaluate a company’s expected performance with different capital structures will use variations of free cash flow like free cash flow for the firm and free cash flow to equity, which are adjusted for interest payments and borrowings.
Similar to sales and earnings, free cash flow is often evaluated on a per share basis to evaluate the effect of dilution.
Understanding Free Cash Flow
Why Free Cash Flow Is Used
Free cash flow is the cash flow available to all the investors in a company, including common stockholders, preferred shareholders, and lenders. Some investors prefer FCF or FCF per share over earnings and earnings per share as a measure of profitability. However, because FCF accounts for investments in property, plant, and equipment it can be lumpy and uneven over time.
Imagine a company has earnings before depreciation, amortization, interest, and taxes (EBITDA) of $1,000,000 in a given year. Also, assume that this company has had no changes in working capital (current assets – current liabilities) but they bought new equipment worth $800,000 at the end of the year. The expense of the new equipment will be spread out over time on the income statement, which evens out the impact on earnings.
However, because FCF accounts for new equipment all at once, the company will report $200,000 FCF ($1,000,000 EBITDA - $800,000 Equipment) on $1,000,000 of EBITDA that year. If we assume that everything else remains the same and there are no further equipment purchases, EBITDA and FCF will be equal again the next year. In this situation, an investor will have to determine why FCF dipped so quickly one year only to return to previous levels, and if that change is likely to continue.
Free Cash Flow (FCF) in Company Analysis
Because FCF accounts for changes in working capital, it can provide important insights into the value of a company and the health of its fundamental trends. For example, a decrease in accounts payable (outflow) could mean that vendors are requiring faster payment. A decrease in accounts receivable (inflow) means the company is collecting from its clients more quickly. An increase in inventory (outflow) could indicate a building stockpile of unsold products. Including working capital in a measure of profitability provides an insight that is missing from the income statement.
For example, assume that a company had made $50,000,000 per year in net income each year for the last decade. On the surface, that seems stable but what if FCF has been dropping over the last two years as inventories were rising (outflow), customers started to delay payments (outflow) and vendors began demanding faster payments (outflow) from the firm? In this situation, FCF would reveal a serious financial weakness that wouldn’t have been apparent from an examination of the income statement alone.
FCF is also helpful as the starting place for potential shareholders or lenders to evaluate how likely the company will be able to pay their expected dividends or interest. If the company’s debt payments are deducted from FCF (Free Cash Flow to the Firm), a lender would have a better idea for the quality of cash flows available for additional borrowings. Similarly, shareholders can use FCF-interest payments to think about the expected stability of future dividend payments.
Free Cash Flow (FCF) Calculations
FCF can be calculated by starting with Cash Flows from Operating Activities on the Statement of Cash Flows because this number will have already adjusted earnings for interest payments, non-cash expenses, and changes in working capital.
The income statement and balance sheet can also be used to calculate FCF.
Other factors from the income statement, balance sheet and statement of cash flows can be used to arrive at the same calculation. For example, if EBIT was not given, an investor could arrive at the correct calculation in the following way.
While FCF is a useful tool, it is not subject to the same financial disclosure requirements as other line items in the financial statements. This is unfortunate because if you adjust for the fact that CAPEX can make the metric a little “lumpy,” FCF is a good double-check on a company’s reported profitability. Although the effort is worth it, not all investors have the background knowledge or are willing to dedicate the time to calculate the number manually.
How To Define “Good” Free Cash Flow - FCF
Fortunately, most financial websites will provide a summary of FCF or a graph of FCF’s trend for most public companies. However, the real challenge remains: what constitutes good Free Cash Flow? Many companies with very positive Free Cash Flow will have miserable stock trends, and the opposite can also be true.
Using the trend of FCF can help you simplify your analysis.
A concept we can borrow from technical analysts or chartists is to focus on the trend of fundamental performance rather than the absolute values of FCF, earnings, or revenue. If stock prices are a function of the underlying fundamentals, then a positive FCF trend should be correlated with positive stock price trends on average.
A common approach is to use the stability of FCF trends as a measure of risk. If the trend of FCF is stable over the last four to five years, then bullish trends in the stock are less likely to be disrupted in the future. However, falling FCF trends, especially FCF trends that are very different compared to earnings and sales trends, indicate a higher likelihood of negative price performance.
This approach ignores the absolute value of FCF to focus on the slope of FCF and its relationship to price performance. Consider the following example:
What would you conclude about a stock’s likely price trend with diverging fundamental performance?
Based on these trends, an investor would be on alert that something may not be going well with the company, but that the issues haven’t made it to the so-called “headline numbers” – revenue and earnings per share (EPS). What could cause these issues?
Investing in Growth
A company could have diverging trends like these because management is investing in property, plant, and equipment to grow the business. In the previous example, an investor could detect that this is the case by looking to see if CAPEX was becoming larger in 2016-2018. If FCF + CAPEX were still upwardly trending, this scenario could be a good thing for the stock’s value.
Between 2015 and 2016, Deckers Outdoor Corp (DECK), famous for their UGG boots, grew sales by a little more than 3%. However, inventory grew by more than 26%, which caused FCF to fall that year even though revenue was rising. Using this information, an investor may have wanted to investigate whether DECK would be able to resolve their inventory issues or if the UGG boot was simply falling out of fashion, before making an investment with the potential for extra risk.
A change in working capital can be caused by inventory or a shift in accounts payable and receivable. If a company’s sales are struggling so they extend more generous payment terms to their clients, accounts receivable will rise, which is a negative adjustment to FCF. Alternatively, perhaps a company’s suppliers are not willing to extend credit as generously and require faster payment. That will reduce accounts payable, which is also a negative adjustment to FCF.
From 2009 through 2015 many solar companies were dealing with this exact kind of credit problem. Sales and income could be inflated by offering more generous terms to clients. However, because this issue was widely known in the industry, suppliers were less willing to extend terms and wanted to be paid by solar companies faster. In this situation, the divergence between the fundamental trends was apparent in FCF but not immediately obvious by just examining the income statement alone.
Free Cash Flow reconciles net income by adjusting for non-cash expenses, changes in working capital, and capital expenditures (CAPEX). As a measure of profitability, it is more uneven than net income but can reveal problems in the fundamentals before they arise on the income statement.