The company’s cash flows are considered its lifeline and the most important parameter to determine its financial stability and viability. But do you know that having positive cash flows is not a sufficient indication that the company is up for expansion and distributing dividends? So, how do you determine a company’s true financial health beyond the mere cash flows? The answer is in its free cash flows and its use. Now let us go to the key question: what are free cash flows and why are they important? Check out this blog to learn all about this term and its uses, and enhance your journey of fundamental analysis of stocks.
We have seen the meaning and uses of cash flow statements in our previous blog. Now we are going a step further with our analysis of the cash flows in this blog and exploring its related term, the free cash flows.
Free cash flows are the funds that a company has left over after it has paid for all its basic operating expenses like salaries, rent, and the cost of making products or running its business, as well as capital expenditures like any investments it needs to keep the business running such as buying new strategic assets (plant and machinery) and maintaining them. Free cash flows are an important factor in determining the actual cash generated by the company to meet its additional commitments, like paying dividends, debt repayment, or reinvesting in growth.
The formula to calculate free cash flow is,
Free Cash Flow = Operating Cash Flow - Capital Expenditure
A company with strong and growing free cash flow is usually considered financially healthy, as it means the business is not just earning profits on paper but is actually bringing in real money that can be translated into its growth and expansion. A negative free cash flow, on the other hand, may indicate that the company is investing heavily in growth or facing financial challenges.
Free Cash Flow (FCF) is a key financial measure that tells investors how much real cash a company generates after taking care of all its expenses and investments. There are mainly two types of Free Cash Flow, i.e., Free Cash Flow to the Firm (FCFF) and Free Cash Flow to Equity (FCFE). Here is a brief analysis of the same.
Free Cash Flow to the Firm is also known as the unlevered free cash flow. It shows the cash available to all the investors of the country, which includes the equity shareholders and lenders (banks and other debt holders). It reflects the cash generated by the company before paying its interest on debts. The FCFF is used while analysing the company as a whole, especially in the case of mergers and acquisitions or business valuations.
The formula to calculate the Free Cash Flow to the Firm is,
Free Cash Flow to the Firm (FCFF) = Net Income + Non-cash Expenses (like Depreciation) + Interest (after tax) - Capital Expenditure - Changes in Working Capital
Free Cash Flow to Equity is the other type of free cash flow, also known as the levered free cash flow. FCFE reflects the cash available for the equity shareholders, i.e., the owners of the company, after paying interest on debt and repaying loan amounts. This is, therefore, a more direct measure for retail investors because it shows the cash available that could be used for dividends or share buybacks.
The formula to calculate the Free Cash Flow to Equity (FCFE) is,
FCFE = Net Income + Non-cash Expenses - Capital Expenditure - Changes in Working Capital + Net Borrowing (New Loans - Loan Repayments)
The free cash flow is an important tool for investors to understand the financial health of the company. The importance and uses of the free cash flow can be explained hereunder.
Indicates Business Strength - Companies with strong free cash flow can handle tough times, invest in growth, and still reward shareholders. It is a sign of a solid and stable business.
Helps in Avoiding Debt Traps - A company that generates enough free cash flow does not need to rely heavily on loans to survive or grow. This reduces financial risk for investors.
Shows Real Financial Health - Profits can sometimes be adjusted using accounting tricks, but free cash flow shows the actual cash generated. It gives a clearer picture of the company’s real financial condition.
Supports Long-Term Growth - FCF helps fund new projects, research, and expansion plans without needing to borrow money or issue new shares by giving a clear idea of the funds at disposal.
Check for Dividend Potential - A company with FCF is more likely to give regular dividends or even increase them over time as compared to a company with no FCF.
Evaluate Share Buybacks - Companies with extra cash at hand can buy back their shares, which can lead to an increase in the value of each share. This benefits long-term investors.
Spot Red Flags - FCF can also be used to spot red flags within the company. A company that shows high profits but low or negative FCF may have issues with cash management. This can be a warning sign for investors.
Compare Companies - Investors can use FCF to compare two or more companies in the same industry. The one with higher and consistent free cash flow is often a better investment.
Although FCF is an important metric in the fundamental analysis of a company. However, it has a few limitations that need to be considered as well. Here is a brief analysis of the same.
FCF may not always be steady and can be negative even for good companies when they are investing heavily in expansion, which does not necessarily translate into trouble.
It is a difficult measure of comparison across industries or different sectors due to differences in spending and debt levels.
FCF cannot be used as a standalone factor to determine financial health, and hence needs deeper analysis as
FCF may be affected by one-time events, which can make it look better or worse than usual.
FCF is a powerful tool that helps investors understand how much real cash a company has after covering all its costs and investments. It thus gives a clearer picture of a company’s financial health than profits alone. However, investors and other stakeholders have to consider the limitations of using the free cash flows to make effective investment decisions.
This blog is part of our series on ‘how to read financial statements of a company’. Let us know your thoughts on this topic or if you need further information on the same.
Till then, Happy Reading!
Read More: How to Read a Balance Sheet
Marisha Bhatt is a financial content writer @TrueData.
She writes with the sole aim of simplifying complex financial concepts and jargon while attempting to clarify technical and fundamental analysis concepts of the stock markets. The ultimate goal is to spread vital knowledge and benefit the maximum audience. Her Chartered Accountant background acts as the knowledge base to help clarify crucial concepts and create a sound investment portfolio.
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