What Is Free Cash Flow (FCF)?

Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.

Interest payments are excluded from the generally accepted definition of free cash flow. Investment bankers and analysts who need to evaluate a company’s expected performance with different capital structures will use variations of free cash flow like free cash flow for the firm and free cash flow to equity, which are adjusted for interest payments and borrowings.

KEY TAKEAWAYS

Free cash flow (FCF) represents the cash available for the company to repay creditors or pay dividends and interest to investors.

FCF reconciles net income by adjusting for non-cash expenses, changes in working capital, and capital expenditures (CAPEX).

However, as a supplemental tool for analysis, FCF can reveal problems in the fundamentals before they arise on the income statement.

Understanding Free Cash Flow (FCF)

Free cash flow (FCF) is the cash flow available for the company to repay creditors or pay dividends and interest to investors. Some investors prefer to use FCF or FCF per share over earnings or earnings per share as a measure of profitability because these metrics remove non-cash items from the income statement. However, because FCF accounts for investments in property, plant, and equipment, it can be lumpy and uneven over time.

Benefits of Free Cash Flow (FCF)

Because FCF accounts for changes in working capital, it can provide important insights into the value of a company and the health of its fundamental trends. A decrease in accounts payable (outflow) could mean that vendors are requiring faster payment. A decrease in accounts receivable (inflow) could mean the company is collecting cash from its customers quicker. An increase in inventory (outflow) could indicate a building stockpile of unsold products. Including working capital in a measure of profitability provides an insight that is missing from the income statement.

How to Define “Good” Free Cash Flow (FCF)

Fortunately, most financial websites will provide a summary of FCF or a graph of FCF’s trend for most public companies. However, the real challenge remains: what constitutes good Free Cash Flow? Many companies with very positive Free Cash Flow also have dismal stock trends, and the opposite can also be true.

Using the trend of FCF can help you simplify your analysis.

One important concept from technical analysts is to focus on the trend over time of fundamental performance rather than the absolute values of FCF, earnings, or revenue. Essentially, if stock prices are a function of the underlying fundamentals, then a positive FCF trend should be correlated with positive stock price trends on average.

A common approach is to use the stability of FCF trends as a measure of risk. If the trend of FCF is stable over the last four to five years, then bullish trends in the stock are less likely to be disrupted in the future. However, falling FCF trends, especially FCF trends that are very different compared to earnings and sales trends, indicate a higher likelihood of negative price performance in the future.

This approach ignores the absolute value of FCF to focus on the slope of FCF and its relationship to price performance.

What Does FCF Indicate?

Free Cash Flow (FCF) indicates the amount of cash generated each year that is free and clear of all internal or external obligations. In other words, it reflects cash that the company can safely invest or distribute to shareholders. While a healthy FCF metric is generally seen as a positive sign by investors, it is important to understand the context behind the figure. For instance, a company might show high FCF because it is postponing important CAPEX investments, in which case the high FCF could actually present an early indication of problems in the future.

How Important Is FCF?

Free Cash Flow (FCF) is an important financial metric because it represents the actual amount of cash at a company’s disposal. A company with consistently low or negative FCF might be forced into costly rounds of fundraising in an effort to remain solvent. Similarly, if a company has enough FCF to maintain its current operations, but not enough FCF to invest in growing its business, that company might eventually fall behind its competitors. For yield-oriented investors, FCF is also important for understanding the sustainability of a company’s dividend payments, as well as the likelihood of a company raising their dividends in the future.