What It Is:
Free cash flow (FCF) is a measure of how much cash a business generates after accounting for capital expenditures such as buildings or equipment. This cash can be used for expansion, dividends, reducing debt, or other purposes. The formula for free cash flow is:
FCF = Operating Cash Flow - Capital Expenditures
How It Works/Example:
The data needed to calculate a company's free cash flow is usually on its cash flow statement. For example, if Company XYZ's cash flow statement reported $15 million of cash from operations and $5 million of capital expenditures for the year, then Company XYZ's free cash flow was $15 million - $5 million = $10 million.
It is important to note that free cash flow relies heavily on the state of a company's cash from operations, which in turn is heavily influenced by the company's net income. Thus, when the company has recorded a significant amount of gains or expenses that are not directly related to the company's normal core business (a one-time gain on the sale of an asset, for example), the analyst or investor should carefully exclude those from the free cash flow calculation to get a better picture of the company's normal cash-generating ability.
Investors should also be aware that companies can influence their free cash flow by lengthening the time they take to pay the bills (thus preserving their cash), shortening the time it takes to collect what's owed to them (accelerating the receipt of cash), and putting off buying inventory (again, preserving cash). It is also important to note that companies have some leeway about what items are or are not considered capital expenditures, and the investor should be aware of this when comparing the free cash flow of different companies.
Why It Matters:
The presence of free cash flow indicates that a company has cash to expand, develop new products, buy back stock, pay dividends, or reduce its debt. High or rising free cash flow is often a sign of a healthy company that is thriving in its current environment. Furthermore, since FCF has a direct impact on the worth of a company, investors often hunt for companies that have high or improving free cash flow but undervalued share prices -- the disparity often means the share price will soon increase.
Free cash flow measures a company's ability to generate cash, which is a fundamental basis for stock pricing. This is why some people value free cash flow more than just about any other financial measure out there, including earnings per share.
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