What is Free Cash Flow?

Notes from the video ‘Diffusion Academy| Finance |Free Cash Flow?‘ :

What is free cash flow?

Free cash flow is a measure of how much cash a company is able to generate after taking into account capital expenditures such as buildings, property and equipment.

 

You can calculate free cash flow using this formula:

Free Cash Flow equals to Operating Cash Flow minus Capital Expenditure.

You can get the data on operating cash flow and capital expenditure from the company’s cash flow statement.

You can get the operating cash flow in the Operating Cash Flow section and the capital expenditure in the Investing Cash Flow section.

 

If you do not have the cash flow statement, it’s also possible to calculate a company’s free cash flow if you have the company’s income statement and balance sheet.

You can calculate the company’s operating cash flow by adding non-cash expenses such as depreciation and amortization and changes in working capital to the net income.

You can calculate the company’s capital expenditure by adding depreciation expenses to the current period Property, Plant and Equipment and subtracting the prior period Property, Plant and Equipment.

 

Free cash flow is an important indicator of a company’s financial health and is essential for making key business decisions for the company.

A company that has a healthy free cash flow should have enough money for their capital expenditures and some left over for other expenses.

A company with high or rising free cash flow is often a sign that it is doing very well.

This excess cash can be used for expansion, developing new products or paying dividends.

On the other hand, a company that has a low free cash flow, i.e. no or little cash left after paying its capital expenditure, may need to restructure.

 

Since free cash flow has a direct impact on the worth of a company, investors are often looking for companies with high or improving free cash flow and an undervalued share price.

In fact, some investors value free cash flow more than other financial measures including earnings because they give a much clearer view of a company’s ability to generate cash.

 

However, it is important for investors to look at the company’s free cash flow over a period of time to get a clearer picture of the company’s financial performance.

This is because a company’s free cash flow for a given year could be misleading.

For example, a company could have high free cash flow for that year because it had a significant one-time gain on the sale of an asset which is not related to the company’s core business.

 

Or a company could have a negative free cash flow for a given year because it made huge investments that year.

If these investments have high returns, they could pay off for the company in the long term.

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