What Is Free Cash Flow (FCF)?

Meaning & Calculation

Introduction to Free Cash Flow

While analyzing a company we give a lot of importance to the Net Profit of the company. No doubt that it is an important factor, but Free cash Flow is an equally important factor. In this article, we are going to discuss what is free cash flow?

Like some analysts look at Earning Per Share (EPS), similarly one can analyze the company using Free Cash Flow Per Share. Free Cash Flow is specifically important for those companies in capital intensive businesses. It is also of importance for analysis of the companies which have high debt.

Thus, while analysis of a company free cash flow should also be given weightage. Free Cash Flow should always be positive. In some years it can go negative but there will obviously be reason behind it and shouldn’t be repeated.

Analysis of Free Cash Flow

• One should track Free Cash Flow Year-on-Year, that is should only be looked at when the final numbers for that year of the company are declared.
• It is not useful to analyse it in between or on quarterly basis as a lot of changes can happen during the whole year.

Calculation of Cash Flow

Following are the steps of how cash flow can be calculated.

1. Cash From Operating Activities

Important Factors under this:

• Operating Profit – It is the nothing but the cash generated from the core activities of the company. Here, only the cash already received is taken into consideration and not the cash to be received. You cannot bank on receivables in this case. This is added to the cash flow.
• Working Capital – Working capital is nothing but the amount received after subtracting the amount of current liabilities from current assets. One should look at Changes in the working capital also. If the changes are positive then add them, but if negative then subtract them from the cash flow.
• Taxes – Here, both the tax on profits as well as dividend distribution tax are to be included. They get reduced from the cash flow.

Working capital might go negative sometimes when the current liabilities exceed the current assets. And obviously one pays taxes if there are profits. But, in the end, Profit from Operations should always be positive.

2. Cash From Investment Activities

Important Factors under this:

• Fixed Asset Purchase – When a company buys fixed assets, liquidity of the company gets used up. This doesn’t happen every year, but when it does, that time it is a negative entry in the cash flow.
• Fixed Asset Sale – When a company sells fixed assets, liquidity of the company gets goes up. Here, the cash flow will become positive as the cash from sale comes into the account.
• Investment Purchase – If there is liquidity available with the company, the company, for example, can park those funds in liquid funds or in fixed deposits. This is regarded as investments purchased. This factor again reduces the cash flow.
• Investment Sale – When the maturity of an investment is reached or the company redeems the investment, that time the cash comes into the account and is added to the cash flow.

If there is purchasing activity then there will be a outflow in cash flow, and for selling activity then inflow in cash flow takes place.

3. Cash From Financing Activities

Important Factors under this:

• Loans Taken – Here, the money will be added to the cash flow.
• Loans Repaid – Money from the cash flow will go out.
• Interest Payment – If a loan is taken, then interest would have to be paid on it. When interest is paid, the amount is subtracted from the cash flow.
• Dividend Paid – If a company pays dividend to its shareholders, then the amount is subtracted from the cash flow.

Summary

• In the end, when all the addition and subtractions entries are the done, the amount that is received if positive is termed as Positive Free Cash Flow and if in minus then is termed as Negative Free Cash Flow.
• Continuously negative free cash flow is definitely not good and is an alarming sign. It can be acceptable if it is just a hiccup and does not get repeated again and again. It can happen when certain purchases or investments are made in that year.
• Investors, such as Warren Buffet, rely heavily on free cash flow.
• Therefore, it is very important for a company to have positive FCF. Also, companies in capital-intensive businesses and companies with high debt should not consistently have Negative FCF.