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Free cash flow (FCF)

Free cash flow (FCF)

Free cash flow represents the cash that a company produces through its business operations minus any capital expenditure on maintaining or improving its assets, such as plant and machinery. The cash remaining is thus 'free' to be deployed as the company and its owners decide.

Key takeaways:

  • Free cash flow (FCF) is a financial metric that measures the amount of cash generated by a company's operations after accounting for capital expenditures and working capital requirements.
  • Free cash flow represents the cash available to the company for various purposes, such as paying dividends, reducing debt, investing in growth opportunities, or returning value to shareholders.
  • FCF is calculated by subtracting capital expenditures (CAPEX) and changes in working capital from a company's operating cash flow.

  • Free Cash Flow is considered an important indicator of a company's financial health, sustainability, and ability to generate cash returns for shareholders.

Where have you heard about free cash flow (FCF)?

As an investor, you may have seen figures for free cash flow (FCF) given in the reports of companies in which you are invested. Financial media sometimes refer to FCF when reporting on the health or otherwise of specific firms.

Calculating free cash flow

How to calculate free cash flow:

  1. Start with the company's operating cash flow (OCF) from its cash flow statement. This can typically be found in the annual report or financial statements.
  2. Subtract capital expenditures (CAPEX) or the amount spent on long-term assets, such as property, equipment, or investments. This information is also available in the cash flow statement or notes to the financial statements.
  3. Adjust for changes in working capital. Working capital refers to current assets (e.g., inventory, accounts receivable) and current liabilities (e.g., accounts payable) used in day-to-day operations. Calculate the difference in working capital from the previous period to the current period and adjust the cash flow accordingly.
  4. The resulting value is the free cash flow (FCF) for the specific period.

 

The formula for calculating free cash flow is:

EBIT (1-tax rate) + (depreciation) + (amortization) - (change in net working capital) - (capital expenditure)

What you need to know about free cash flow (FCF)

The purposes to which free cash flow can be put include:

  • Research and development
  • Corporate acquisitions
  • The payment of dividends (this last being of special interest to shareholders)

 

FCF is considered by some to be a true reflection of a firm's ability to generate profits as earnings can be adjusted by various accounting practices. For example, in start-ups FCF may turn negative for a while as it makes substantial investments. Assuming these pay off, FCF will subsequently turn positive.

Find out more about free cash flow (FCF)

FCF figures are a key element in financial reporting. Learn more about financial reports here.

How do you calculate free cash flow?

FCF = Cash from Operations - Capital Expenditures

To calculate free cash flow, you need to gather the necessary financial information from the company's financial statements, specifically the statement of cash flows and the statement of cash flows.

What is a good FCF ratio?

A “good” free cash flow conversion rate would typically be consistently around or above 100%, as it indicates efficient working capital management. A higher free cash flow margin generally indicates that a company is generating more cash relative to its revenue, which can be seen as a positive sign. However, what constitutes a "good" FCF ratio or margin can vary depending on the industry, company size, and business model. It's essential to compare a company's FCF ratio to its historical performance, as well as benchmark it against industry peers to gain meaningful insights.

Should free cash flow be high or low?

In general, a higher free cash flow (FCF) is seen as favorable because it indicates that a company is generating more cash from its operations than it is consuming. A positive and increasing FCF suggests that a company has the ability to fund its operations, invest in growth opportunities, pay dividends, reduce debt, or engage in other value-creating activities.

What does free cash flow (FCF) tell you?

Free cash flow (FCF) provides valuable insights into a company's financial health and operational efficiency.

What is the difference between free cash flow and net cash flow?

Free cash flow (FCF) and net cash flow are related but distinct financial metrics.

Free cash flow: Free cash flow is a measure of the cash generated by a company's operations that is available for distribution to investors, debt repayment, or reinvestment in the business.

Net cash flow: Net cash flow, on the other hand, refers to the difference between cash inflows and cash outflows during a specific period.

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