Investment Concepts - Free Cash Flow (FCF)
One metric often mentioned when analysing a stock it its Free Cash Flow (FCF). FCF is a company's cash flow after subtracting capital expenditures, representing the cash generated after spending to maintain or increase the asset base.
While there are a few different ways to calculate it, generally FCF is calculated with the following formula:
Cash flow from operations - Capital expenditures
Other cash events such as dividends/share buybacks are not captured as FCF is intended to show the company's cash flow generated from its core business.
FCF is important for several reasons. The most basic being that it shows the amount of actual cash generated. As is apparent in life, cash in hand is most important as it is needed to pay off expenses and overheads, and if a business is not generating cash, it is unlikely to survive long.
In contrast, the income statement is not necessarily representative of the cash flows of the Company. Even when profits are good, due to the rules for recognising profits, it may not mean the company has sufficient cash to meet its expenses. Some analysts thus find that the market is too earnings focused, and advocate scrutiny of FCF as well.
FCF helps to complete the picture of the company given by the income statement. The income statement is much more easily manipulated, allowing the impact of large purchases to be spread over a number of years via depreciation policies, and timing earnings and expenses in a way which suits management. The income statement also fails to capture information such as the pre-purchase of inventory, or differences between payment and receiving/selling goods. In contrast, the amount of cash held by the Company is a fact and cannot be manipulated as easily,
A good sign of health would be having a positive FCF over a few periods, and even better if the amount of cash is grows each year. This is particularly true for asset light businesses. If a business is asset heavy, then FCF is likely to be volatile as funds are spent on capital expenditures.
Good cash flow means the company will have more cash to pay its liabilities and thus more likely to survive well, and also have excess cash to pay dividends, or to pursue growth through asset acquisitions. However, a negative FCF may not always be a bad thing, it is more of a red flag to signal that further analysis is required on the reasons why cash flow is bad. For example, while negative FCF is a dangerous sign for a mature company, a company in a growth stage might be aggressively spending cash to expand. Or, a company may have good cash reserves and is using its cash to prepare itself for long term growth. An investor must ask whether the negative FCF is a sign of a recurring problem, or perhaps a one-off or short term effect.
FCF should also not be analysed in a vacuum, it must first be considered on a year on year basis, and also against other similar companies as a benchmark. When comparing different companies, Free Cash Flow Yield (FCF / Market Cap) can be used to make the comparison. If this is done across industries, then FCF yield can be calculated using (FCF/Enterprise Value)
The current economic climate may also be relevant, whether there are available assets for purchase, or if there are hints of a recession and the company should start building a cash buffer.
Even if FCF is positive, it is important to ask whether the reasons for this are sustainable, and if the FCF is in line with earnings. Positive FCF may not be due to greater sales, but due to cost cutting which may not be sustainable, or because the company is failing to make capital expenditures and may not have long term prospects.