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 t