Free cash flow is one of, if not the most influential figures in financial valuation. It holds the keys to a company’s value and shapes investor sentiment. However, free cash flow is sometimes overlooked in favour of more readily available figures like revenue and net profit.
So, what is free cash flow, how is it calculated, and why is it important to investors?
What Is Free Cash Flow (FCF)?
Free cash flow (FCF) represents a company’s residual cash after accounting for operating expenses (like wages and selling and distribution costs) and capital reinvestments (money spent on maintaining existing company assets or buying new ones).
Free cash flow highlights a company’s financial health by showing the funds available for business growth, debt reduction and shareholder rewards (dividends and share repurchases).
It also provides a more accurate measure of profitability by stripping out all non-cash items from the statement of profit or loss (income statement) and accounting for all non-cash working capital changes on the statement of financial position (balance sheet).
Why Non-Cash Items Are Stripped Out When Calculating Free Cash Flow
Non-cash expenses (like depreciation and amortisation) are often called accounting expenses, meaning cash isn’t paid for them. These expenses represent the annual decline in an asset’s value over its lifetime.
Since no cash payments are made for these expenses, their impacts are reversed in the calculation of free cash flow.
Similarly, non-cash gains (like the profit on asset sales) are stripped out because no cash was received. Therefore, their impacts are also reversed.
For a more in-depth explanation, click here and go to “Non-Cash Items” in the “CFO Components and Their Impact” section.
Why Changes in Non-Cash Working Capital Are Accounted For When Calculating Free Cash Flow
Changes in Non-Cash Working Capital reflect the changes in non-cash current assets and non-cash current liabilities. These are included in the calculation of free cash flow since cash is used to acquire current assets (inventory), is expected to be received from current assets (accounts receivable) and pays for current liabilities (accounts payable).
For a more in-depth explanation, click here and go to “Changes in Non-Cash Working Capital” in the “CFO Components and Their Impact” section.
Free Cash Flow Formula
Free cash flow (FCF) is calculated directly from a company’s statement of cash flows.
In its simplest form, the free cash flow formula is as follows.
Net Cash From Operating Activities represents the cash generated from a company’s core operations and is found in the first third of the statement of cash flows.
Capital expenditure, CapEx for short, is found in the middle third of the statement of cash flows. It represents all the cash a company spends to maintain existing or acquire new capital assets (the assets needed to continue operating).
You won’t see the terms ‘capital expenditure’ or ‘CapEx’ on a company’s statement of cash flows. Capital expenditure is presented under one of the following names:
- Acquisitions of property, plant and equipment
- Purchases of property, plant and equipment
- Property, plant and equipment
Companies sometimes change the terminology to reflect the kind of business they’re in. For example, as a payment processing company, Visa uses the term ‘Purchases of property, equipment and technology’.
Investors often use the terms ‘capital expenditure’ and ‘CapEx’ to avoid the name on the statement (it takes too much time and effort to say).
Real-World Calculation Example
To illustrate how free cash flow is calculated, we will use financials from Visa’s 2023 Annual Report.
Extracts from the company’s statement of cash flows are as follows.
| $ in millions | |
| Net Cash From Operating Activities | 20,755 |
| Purchases of Property, Equipment and Technology | 1,059 |
Using the following formula:
Visa’s 2023 free cash flow was $19,696 ($19.6 billion).
| $ in millions | |
| Net Cash From Operating Activities | 20,755 |
| (-) Purchases of Property, Plant and Equipment | 1,059 |
| Free Cash Flow | 19,696 |
Visa then used this $19.6 billion to reduce debt by $2.3 billion and reward their shareholders with dividends ($3.8 billion) and share buybacks ($12.1 billion).
Why Investors Look At Free Cash Flow
Since free cash flow is a profitability figure, it can be used to gauge a company’s financial performance over time.
Unlike annual profits, free cash flow focuses on the cash generated during the year after accounting for operating expenses and capital expenditures. Analysing a company’s free cash flow trend offers a clearer understanding of its cash-generating ability and overall profitability.
Besides assessing a company’s financial performance, investors also look at free cash flows for the following reasons.
It’s Central To Company Valuation
Free cash flow is significant to investors, especially those with a long-term perspective, as it is central to the valuation process.
Investors often value companies using the discounted cash flow (DCF) model. This model discounts the investor’s estimates of a company’s future free cash flows to determine what it’s worth (its intrinsic value) and what to pay for its shares.
In other words, investors use free cash flows to determine whether or not to buy shares in a company.
Because of its inherent link to intrinsic value, investors are attracted to companies with growing annual free cash flows. As free cash flows increase, so does the company’s value (and stock price). Fundamentally, a company with increasing free cash flows is more valuable than one with stagnating free cash flows.
Think about it.
A money printer that prints £100 initially but increases the amount printed daily by £1 would be worth more than a money printer that prints £100 daily.
This same principle applies to companies in the financial world.
Competitive Advantages
A company with consistently growing free cash flows can be a sign of a competitive advantage.
A trend of growing free cash flows can indicate a company is operating efficiently. This can manifest through cost advantages (being the lowest-cost producer of a product) or technological advances (using cutting-edge technologies to reduce wastage).
Competitive advantages allow companies to generate proportionately higher amounts of free cash flow with proportionately lower increases in operating costs. This will improve free cash flow margins (how much revenue is converted to free cash flow), making the company more profitable and valuable.
Early Red Flag Detection
While rising free cash flows can indicate a competitive advantage, fluctuating or declining free cash flows can reveal company issues before they appear in other financial statements.
Fluctuating or declining free cash flows may suggest operating inefficiencies, such as difficulties collecting payments from customers who buy on credit. These inefficiencies can be masked in the statement of profit or loss (income statement) by making legal accounting adjustments and deferring expenses to future periods.
With cash, it’s either there or not. Because of this, when free cash flows become unstable, it can alert investors to company issues. Analysing fluctuating or declining free cash flows helps investors make more informed decisions about a company, their investments or potential investments.
What Is A Good FCF Figure?
An acceptable free cash flow figure varies from company to company. Although the figure is significant, what matters more is the company’s free cash flow relative to its revenue, i.e. its free cash flow margin (free cash flow/revenue).
Let’s explore this idea a bit more.
£10 million of free cash flow is a lot of money, but if revenue is £300 million, the company only converts 3% of revenue to free cash flow (the company has a 3% free cash flow margin). Although the company’s free cash flow seems high, the 3% margin suggests otherwise. Relative to its revenue, £10 million is extremely low.
So, alongside an annually increasing free cash flow figure, investors are attracted to companies with high free cash flow margins.
Summary
Free cash flow (FCF) is a key financial figure that reveals a company’s cash after accounting for operating expenses and capital expenditures. It provides a clearer picture of a company’s financial health than profit alone, showing the cash available for debt reduction and shareholder rewards.
In its simplest form, free cash flow is calculated by subtracting capital expenditures from net cash from operating activities. Investors then use free cash flow to assess a company’s profitability and financial performance, determine its intrinsic value, recognise potential competitive advantages and detect possible red flags.
An acceptable free cash flow figure varies from company to company. However, investors look for companies with annually increasing free cash flows and high free cash flow margins.
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