What is the Definition of Free Cash Flow, and Why is it so Important?
Free cash flow (FCF) is a metric that measures the cash generated by a business that is available for distribution to its investors, including shareholders and creditors. Free cash flow is a crucial financial metric for businesses, as it can be used to pay dividends, repay debt, invest in growth opportunities, and fund share repurchases.
Profit and free cash flow are both important financial metrics and similar in nature, but they measure different aspects of a company's financial performance.
Profit, also known as net income, is the amount of money a company earns after deducting all expenses, including taxes, from its total revenues. Profit is calculated on an accounting basis, which means it includes non-cash expenses such as depreciation and amortization.
Free cash flow, on the other hand, is the cash generated by a company's operations that is available for distribution to investors or for reinvestment in the company's growth. FCF takes into account capital expenditures, which are the expenses a company incurs to maintain or expand its business operations. This includes things like buying new equipment, building new facilities, and investing in research and development.
The key difference between profit and free cash flow is that profit is an accounting measure that reflects the company's earnings, whereas free cash flow is a measure of the cash a company generates from its operations. Profit can be impacted by non-cash expenses, such as depreciation, while free cash flow considers the cash that is available after all expenses, including capital expenditures, are paid.
In general, companies that generate positive free cash flow are considered to be financially healthier than those with negative free cash flow, as they have more cash available for investments, dividends, and debt repayment. Profit, on the other hand, can be affected by accounting practices and one-time events, so it's important to consider both metrics when evaluating a company's financial performance.
Free cash flow is calculated by subtracting capital expenditures (CAPEX) from operating cash flow. Operating cash flow is the cash generated by a company's day-to-day operations, including revenues collected from customers and payments made to suppliers and employees. Capital expenditures, on the other hand, represent the cash outflows a company incurs to acquire or upgrade its property, plant, and equipment (PP&E).
The formula for free cash flow is as follows:
Free Cash Flow = Operating Cash Flow - Capital Expenditures
For example, let's say a company generates $1 million in operating cash flow and incurs $500,000 in capital expenditures during a given period. Its free cash flow would be $500,000 ($1 million - $500,000).
Free cash flow is an important metric for investors because it represents the cash a company has left over after paying for its operations and investments. This cash can be used to reward investors, fund future growth initiatives, or pay down debt.
Investors often use free cash flow to assess a company's financial health and growth potential. A company that consistently generates positive free cash flow is generally viewed as a healthier business with more room to invest in growth opportunities. Conversely, a company that consistently generates negative free cash flow may struggle to fund its operations and growth initiatives and may have to rely on external sources of financing.
Here are some specific reasons why free cash flow is important:
- Shows financial health: FCF indicates how much cash a company has available to pay dividends, buy back stock, pay down debt, or invest in new projects. Companies with positive free cash flow are generally considered to be financially healthier than those with negative free cash flow, as they are generating more cash than they are spending on capital expenditures.
- Helps predict future growth: A company's free cash flow can help predict its future growth potential. Positive FCF means that a company has the financial flexibility to invest in new projects or acquire other companies. On the other hand, negative free cash flow can signal that a company may need to take on more debt or issue more shares to fund growth.
- Measures profitability: FCF is a measure of a company's profitability, as it indicates how much cash a company generates from its operations. Companies that consistently generate positive free cash flow are generally considered more profitable than those with negative FCF.
- Evaluates dividend payments: Investors often look at free cash flow when evaluating a company's ability to pay dividends. Positive FCF indicates that a company has enough cash to pay dividends to shareholders without relying on debt or other external funding sources.
Overall, free cash flow is an important financial metric that provides insights into a company's financial health, profitability, growth potential, and ability to pay dividends. By considering free cash flow, investors can gain a deeper understanding of a company's financial position and make more informed investment decisions.