What is free cash flow?

Free cash flow is the net change in cash generated by the operations of a business during a reporting period, minus cash outlays for working capital, capital expenditures, and dividends during the same period. Thus, the calculation is:

Free cash flow = Operating cash flow - Working capital changes
- Capital expenditures - Dividends

The "operating cash flow" component of that equation is calculated as:

Operating cash flow = Net income + Depreciation + Amortization

Free cash flow is important because it is an indicator of the financial health of a business, and particularly of its ability to invest in new business opportunities. It is also used by investors to estimate the amount of cash flow that may be available for distribution to them in the form of dividends. However, there can be a variety of situations in which a company can report positive free cash flow, and which are due to circumstances not necessarily related to a healthy long-term situation. For example, positive free cash flow can be caused by:

• Selling off major corporate assets
• Cutting back on or delaying capital expenditures
• Delaying the payment of accounts payable
• Foregoing a dividend
• Cutting back on key maintenance expenditures
• Reducing marketing expenditures
• Curtailing scheduled pay increases
• Entering into sale and lease back arrangements for key assets

In these examples, management has taken steps to reduce the long-term viability of a business in order to improve its short-term free cash flows. Other actions, such as accelerating the collection of accounts receivable or switching to just-in-time materials management systems, can be beneficial to a business while still reducing its outgoing cash flows.

Free cash flow can also be impacted by the growth rate of a business. If a company is growing rapidly, then it requires a significant investment in accounts receivable and inventory, which increases its working capital investment and therefore decreases the amount of free cash flow. Conversely, if a business is shrinking, it is converting some of its working capital back into cash as receivables are paid off and inventory liquidated, resulting in an increasing amount of free cash flow.

Thus, you should be aware of the general condition and strategic direction of a business when evaluating whether the state of its free cash flows are beneficial or not.

Related Topics

Financial statement analysis
Horizontal analysis
Incremental cash flow analysis
Profit velocity analysis
Vertical analysis