To those unfamiliar with the term, free cash flow may sound confusing, after all when is cash free. However, it makes sense when you understand what it is.
Think about cash coming into a company from the sale of its products or services and follow it through the statement of cash flows.
Some of the cash is used to buy materials and/or pay wages. Some of the cash pays the bills (utilities, phones, and so on). When the company finishes paying all the bills, what is left is called cash flow from operations.
The company still has other expenses, such as new equipment or other capital expenses (for items that are required for growth, but are not directly related to daily business operations, such as new facilities and large equipment).
Remaining Cash
If the company is doing well, there will be cash remaining after all expenses (including taxes, and so on) are paid.This cash can be paid out as dividends, reinvested in the company, or invested in the market. The company could also choose to buy some of their shares back.
Free cash flow is that money available to the company that is not used in the daily operations of the business.
To find a company’s free cash flow, take cash flow from operations which is found on the statement of cash flows and subtract any capital spending. There are several ways to calculate free cash flow, but this one is straight forward and easy to determine.
Why is it important to know free cash flow?
Taking Cash Out of the Company
Free cash flow is that cash you could take out of the company and not affect its operations.A company that has a history of generating free cash flow and is expected to continue throwing off free cash flow is worth more (meaning its stock should command a higher price), than a company that has an uncertain prospects for generating free cash flow.
What is the “right” amount of free cash flow? That depends on the industry and whether the company in large and stable or young and growing.
For example, a mature software company with a large customer base will probably throw off large sums of free cash flow, while a younger company may have a negative free cash flow.
Having a negative free cash flow is expected for a young, growing company, but a red flag for a mature larger company.
Understanding Free Cash Flow
Understanding free cash flow is the first step to determining the value of a company. When you understand the value of a company, you can determine whether it is under or over-priced.Historically, we understand that the value of a stock is equal to the present value of its future cash flows.
We’ll discuss how to calculate the present value of future cash flows in future columns. However, it is important to understand free cash flow as a basis for taking the next step in determining a value for the company’ stock.
