Free Cash Flow (FCF) is an important financial metric that indicates the cash generated by a company's operating activities after deducting operating expenses and capital expenditures. It is the money that has left after paying the costs to run its business.
Note that it excludes non-cash expenses such as depreciation or amortisation.
Free cash flow vs net cash flow
Before I move on, take note that FCF should not be confused with net cash flow. While net cash flow encompasses cash generated from operating, investing, and financing activities, FCF specifically focuses on the cash generated by a company's operating activities after deducting operating expenses and capital expenditures.
Why do I use free cash flow?
I use FCF to evaluate a company's financial soundness and potential attractiveness for investment. One of the primary benefits of using FCF as an investment tool is that it provides insight into a company's efficiency in generating cash. I can use FCF to assess a company's capacity to pay dividends, buy back shares, reduce debt, or pursue growth opportunities. A company with a positive FCF may have the resources to invest in new projects or make acquisitions. Additionally, FCF is less susceptible to accounting fraud than other financial metrics, making it a reliable measure of a company's financial performance.
Considerations to keep in mind when using free cash flow
While FCF can be a useful metric for evaluating a company's financial health and growth potential, there are several considerations to keep in mind when using FCF.
Investors should be wary of a company's policies that can affect FCF. For instance, a company may intentionally boost its FCF by stretching out payments, tightening payment collection policies or depleting inventories, which may not be sustainable in the long term. Furthermore, different companies may have varying guidelines for declaring assets as capital expenditures, leading to different calculations of FCF.
While a growing FCF is generally a positive sign, an excessively high FCF may indicate that a company is not investing enough in its business. For instance, a company may be neglecting plant and equipment upgrades, which could negatively impact its long-term growth prospects. On the other hand, a negative FCF does not necessarily indicate financial distress; it could result from a company's investment in expansion for future growth.
Take Amazon Inc. as an example. The company reported negative free cash flow since the fiscal year 2021. It may seem that the company is performing badly at first glance. But if you read the company’s annual report, it tells us that Amazon Inc is aggressively investing in its plants and equipment to better serve its customers by improving availability, offering faster delivery and performance times, and increasing selection.
Similarly, a low or declining FCF may not always suggest a failing business if the company is investing in growth opportunities such as acquisitions or new product development.
FCF also does not take into account a company's debt obligations, which can have a significant impact on its financial stability.
How do I evaluate a company’s free cash flow effectively?
To make better evaluations of a company's FCF, I need to analyse it over multiple periods and look beyond the numbers. Investors should read the company's reports to understand its growth strategies while ensuring profitability. Companies need to generate FCF on a sustainable basis and therefore investors need to understand the company's policies that can affect FCF. The best place to read more about the company is its annual report or the company’s 10K.
I also prefer to look at free cash flow per share (FCFPS) rather than FCF alone. FCFPS is a financial metric that measures the amount of free cash flow a company generates per outstanding share of its common stock. It is a better indicator for comparative analysis as the metric evaluates a company's ability to generate cash flow relative to the number of shares outstanding.
In addition, I never rely solely on FCF as the only financial indicator. I consider other financial ratios, such as the price-to-earnings (P/E) ratio, debt-to-EBITA ratio, and return on equity (ROE), to gain a more comprehensive understanding of a company's financial performance. While FCF is a critical metric, it should be used in conjunction with other financial ratios to make informed investment decisions.
Bottom line
FCF is an important financial metric for investors to evaluate a company's financial soundness and potential for investment. Value investors like me use FCF to calculate the company’s intrinsic value. However, investors should be cautious of a company's policies that can affect FCF and analyse it over multiple periods to gain a more accurate understanding of a company's financial performance. FCF should also be used together with other financial ratios to make better investment decisions.
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