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. This is a strong indicator of the ability of an entity to remain in business, since these cash flows are needed to support operations and pay for ongoing capital expenditures.
How to Calculate Free Cash Flow
The free cash flow formula is:
Free cash flow = Operating cash flow - Working capital changes - Capital expenditures - Dividends
The calculation of free cash flow for a nonprofit entity is somewhat different, since a nonprofit does not issue dividends. In this situation, the revised formula is:
Nonprofit free cash flow = Operating cash flow - Working capital changes - Capital expenditures
The "operating cash flow" component of the equation is calculated as:
Importance of Free Cash Flow
The free cash flow model 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. The model 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
The receipt of a large advance payment from a customer
Entering into sale and leaseback 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 through changes in payment terms or switching to just-in-time production 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.
An additional consideration is the ability of a business to repatriate cash from a subsidiary. If a subsidiary is spinning off enormous amounts of cash, it makes little difference to the corporate parent if it cannot access the cash, due to stringent controls over cash repatriation by the applicable government.
Thus, you should be aware of the general condition and strategic direction of a business when evaluating whether its free cash flows are beneficial or not.