This article is for educational purposes and does not constitute financial, legal, or tax advice. For specific advice applicable to your business, please contact a professional.
We all know how essential cash flow is to a company’s finances. It ensures that vendors and employees alike are paid on time. It allows businesses to make capital expenditures without having to resort to high-interest short-term borrowing. It helps to insulate businesses against risk, and ensures that they have the operating cash at their disposal to keep the day-to-day operating activities of their companies running smoothly.
But what is the definition of free cash flow?
Free cash flow is a supplemental tool for analyzing a company’s profitability. It represents the cash generated by a company after accounting for operational expenses, current assets, current liabilities and expenses incurred in maintaining capital assets. As such, free cash flow includes all spending on equipment and assets as well as working capital changes from the balance sheet. However, non-cash expenses listed on the income statement are excluded.
Free cash flow yield is usually expressed on a per-share basis, and is commonly measured against earnings per share (EPS).
Example of free cash flow
High, and even stable, earnings don’t necessarily indicate a healthy free cash flow. And if there is a substantial gulf between revenues and free cash flow, analysts or investors may perceive this as a sign that all is not well with the company’s finances. This is even if issues have not yet begun to affect other metrics like earnings per share.
For example, let’s say that Company X commanded revenue growth from $100,000-$125,000 over the past five years. Earnings per share may also rise from $1 to $1.20. However, free cash flow per share ranges between $0.85 and $1.08.
This may give analysts pause. However, it’s not necessarily an indicator of doom. There are a number of potential causes, including:
How to calculate free cash flow
Calculating free cash flow can be done in two ways.
The first method starts with cash flow from operating activities, then factors in adjustments for capital expenditures, interest expenses and allowances.
The second approach starts with earnings before interest and taxes before factoring in expenses like depreciation and amortization, capital expenditures, income taxes and changes in working capital.
Whichever approach you use will yield the same results. However, the easiest approach for you may vary depending on what information is readily available via your business intelligence software.
Frequently asked questions about free cash flow
What does free cash flow indicate?
Free cash flow indicates how much cash the business has at its disposal to either distribute to shareholders or invest without impinging on operating cash flow. A low cash flow doesn’t necessarily mean that a business is not financially healthy. It may simply be investing in future growth or stockpiling inventory to prepare for an increase in demand.
What is the difference between free cash flow and operating cash flow?
Free cash flow and operating cash flow share some similarities. However, operating cash flow refers to the cash reserves used to cover current liabilities. Free cash flow refers to the cash that is left over after capital expenditures have been accounted for.
What are the limitations of free cash flow?
Free cash flow is a useful measure of cash availability at a given moment. However, a company improving its free cash flow doesn’t necessarily mean that stock trends will improve. A temporary drop in free cash flow may be explained by a heavy investment in equipment to improve productivity and profitability. However, it could also be caused by poor inventory management.