Savvy investors look at a company’s financial health before buying its stock. Some investors monitor a company’s free cash flow and review its cash flow statements to gauge how well it manages its money.
Definition of Free Cash Flow
Free cash flow indicates how much cash a company can produce after taking cash outflows for operations and assets into consideration. Higher free cash flow gives a company more financial flexibility to make investments and sustain operations. Negative free cash flow can be a detriment that may suggest the company has a risky business model and relies on outside funding to stay afloat.
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Here’s what you need to know about calculating free cash flow and other components of a cash flow statement:
— Calculation of free cash flow.
— Example of a free cash flow calculation.
— Reviewing a cash flow statement.
— Free cash flow in financial forecasting.
— Free cash flow in the valuation of a company.
— Drawbacks of using free cash flow.
Calculation of Free Cash Flow
Free cash flow is how much is left over from operating cash flow after capital expenditures. You can use this formula to calculate free cash flow:
Free cash flow (FCF) = operating cash flow – capital expenditures
Let’s break down the individual metrics involved in arriving at a free cash flow figure:
Operating Cash Flow
Operating cash flow can be found on a company’s cash flow statement and tells you how much cash a company generated from its operations during a certain period. Operating cash flow and capital expenditures each have separate formulas.
You have to determine operating cash flow and capital expenditures before you can arrive at free cash flow. Many cash flow statements lay out these items for you, but knowing the formulas can give you a better appreciation of what goes into determining free cash flow.
Net Income vs. Free Cash Flow
In a discussion of cash flow, it’s important to recognize that net income and free cash flow are not the same thing. Net income represents the remaining profit after accounting for a company’s total expenses, while cash flow is related to the rise and fall of a company’s cash balance.
Non-Cash Expenses
Non-cash expenses, for example, represent costs that show up on a balance sheet that do not affect cash. Depreciation and amortization are two common items that show up as non-cash investments. However, you can also find investment gains and losses, stock-based compensation, and impairment charges on the list of non-cash expenses.
Change in Net Working Capital
After adding net income and all of a company’s non-cash expenses, you must then deduct changes in net working capital to arrive at operating cash flow. You must compare year-over-year changes in accounts receivable, inventory and accounts payable to determine change in net working capital.
Capital Expenditures
Then, you must determine capital expenditures. This number is included in the cash flow statement section of a company’s financials, but it can also be calculated by determining the year-over-year change in long-term assets. Find depreciation and amortization on the company’s income statement, then find the property, plant and equipment (PP&E) figure on the balance sheet for both the current and previous period. Subtract the prior PP&E from the current PP&E and add current depreciation to find capital expenditures.
The final step in calculating free cash flow is to deduct capex from operating cash flow.
Example of a Free Cash Flow Calculation
The terms from an equation can look confusing if you haven’t tried out the equation. This example will help you get a better understanding of how to calculate free cash flow. Let’s start with calculating operating cash flow and then move on to calculating capital expenditures.
These are the numbers of a hypothetical company that is calculating operating cash flow:
Net income = $15,000
Non-cash expenses = $5,000
Amortization = $1,000
Depreciation = $2,000
Stock loss = -$1,000
Stock-based compensation = $3,000
Non-cash expenses = $1,000 + $2,000 – $1,000 + $3,000 = $5,000
Net income + non-cash expenses = $20,000
Deducting working capital will help you arrive at operating cash flow. Assume the following details about this hypothetical company:
2023 accounts receivable = $10,000
2022 accounts receivable = $8,000
(Year-over-year change in accounts receivable = $2,000)
2023 inventory = $15,000
2022 inventory = $12,000
(Year-over-year change in inventory = $3,000)
2023 accounts payable = $17,500
2022 accounts payable = $15,000
(Year-over-year change in accounts payable = $2,500)
In this example, the year-over-year changes in accounts receivable, inventory and accounts payable are $2,000, $3,000 and $2,500, respectively. Those amounts add up to $7,500 and represent the change in net working capital.
How to Calculate Operating Cash Flow
Now, to find operating cash flow, use this equation:
Operating cash flow = net income + non-cash expenses – change in net working capital
Operating cash flow = $15,000 + $5,000 – $7,500 = $12,500
[Read: What Is EBITDA in Finance? Meaning and Formula]
How to Calculate Capital Expenditures
After calculating operating cash flow, you must solve for capital expenditures.
Luckily, capital expenditures have a more straightforward calculation, as mentioned earlier. Take the year-over-year change in long-term assets (also known as PP&E), and add depreciation and amortization.
Assume the hypothetical company has $30,000 in long-term assets in 2023, compared with $26,000 in long-term assets in 2022. This represents a $4,000 year-over-year increase, which reduces free cash flow.
Here’s the capital expenditures formula in action:
Capital expenditures (capex) = year-over-year change in long-term assets + depreciation and amortization
Capex = $4,000 + $2,000 + $1,000 = $7,000
(Note: Depreciation is $2,000 and amortization is $1,000 based on non-cash figures above.)
Once you determine operating cash flow and capital expenditures, the rest of the equation is simple. You only have to deduct capital expenditures from operating cash flow to arrive at free cash flow.
Free cash flow = operating cash flow – capital expenditures
Free cash flow = $12,500 – $7,000 = $5,500
Reviewing a Cash Flow Statement
You can save yourself all of these steps by reviewing a company’s cash flow statement. Although this statement contains operating cash flow and other metrics, it’s wise to understand what goes into the calculations. Some investors check how a company arrived at operating cash flow, for example, to assess whether the figure is the right amount or if it seems inflated.
Investors have different preferences for numbers and ratios to include when determining the value of a company and whether they want to buy shares.
Free Cash Flow in Financial Forecasting
Investors use free cash flow to help assess a company’s performance and what lies ahead. Issues in free cash flow often precede issues within income statements as well. Shareholders can look at low or negative free cash flow as a warning to exit a position before other investors notice future problems in income statements.
Dividend investors can look at free cash flow to assess a company’s ability to raise the dividend in the future. Dividend growth investors look for companies that have low payout ratios and growing cash flow. These factors allow corporations to hike their dividends substantially. Declining free cash flow that gets close to a negative amount can indicate that a dividend cut or suspension is on the way.
You can also use cash flow ratios to determine if a company is fairly valued. While many people lean on metrics like the price-to-earnings ratio, or P/E, you can also consider these cash flow ratios:
— Price-to-cash-flow ratio. Share price divided by the cash flow per share.
— Operating cash flow ratio. Operating cash flow divided by current liabilities.
— Cash flow to net income. Operating cash flow divided by net income.
Free Cash Flow in the Valuation of a Company
Good valuations depend on the industry and the opportunity. High-flying tech stocks tend to have loftier valuations due to their potential for rapid growth, while blue-chip companies often have lower valuations.
Comparing corporations’ cash flow ratios can help you determine which investment opportunity is more fairly valued.
Drawbacks of Using Free Cash Flow
Free cash flow is a useful metric, but like many other numbers, it is vulnerable to manipulation. Companies can use accounting methods to inflate free cash flow. These companies can overstate their operating cash flow or understate their capital expenditures.
Both of those scenarios will create the wrong perception of a company’s true free cash flow. Investors may also have different opinions about which line items should be included in operating cash flow and capital expenditures. Any disagreements can result in two investors coming up with different numbers for free cash flow.
Companies can also shed some of their inventory and other long-term assets to create a short-term change in free cash flow. Getting rid of these assets increases a company’s year-over-year cash growth. However, these changes will be short-lived and can result in a steep year-over-year decline in cash flow for the following year.
If you notice a company is only increasing cash flow by selling off its long-term assets, you may have spotted a bad investment in advance.
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What Is Free Cash Flow? Formula and Statement Example originally appeared on usnews.com
