Free Cash Flow:

-Free, But Not Always Easy-

by Ben McClure (Contact Author | Biography)

The best things in life are free, and the same holds true for cash flow.
Smart investors love companies that produce plenty of free cash flow
(FCF). It signals a company's ability to pay debt, pay dividends, buy
back stock and facilitate the growth of business - all important
undertakings from an investor's perspective. However, while free
cash flow is a great gauge of corporate health, it does have its limits
and is not immune to accounting trickery.
What Is Free Cash Flow?
By establishing how much cash a company has after paying its bills
for ongoing activities and growth, FCF is a measure that aims to cut
through the arbitrariness and "guesstimations" involved in reported
earnings. Regardless of whether a cash outlay is counted as an
expense in the calculation of income or turned into an asset on the
balance sheet, free cash flow tracks the money.
To calculate FCF, make a beeline for the company's cash flow
statement and balance sheet. There you will find the item cash flow
from operations (also referred to as "operating cash"). From this
number subtract estimated capital expenditure required for current
operations:

Cash Flow From Operations (Operating Cash)

- Capital Expenditure
---------------------------
= Free Cash Flow
To do it another way, grab the income statement and balance sheet.
Start with net income and add back charges for depreciation and
amortization. Make an additional adjustment for changes in working
capital, which is done by subtracting current liabilities from current
assets. Then subtract capital expenditure, or spending on plants and
equipment:

Net income
+ Depreciation/Amortization
- Change in Working Capital
- Capital Expenditure
----------------------------
= Free Cash Flow

It might seem odd to add back depreciation/amortization since it

accounts for capital spending. The reasoning behind the adjustment,
however, is that free cash flow is meant to measure money being
spent right now, not transactions that happened in the past. This
makes FCF a useful instrument for identifying growing companies
with high up-front costs, which may eat into earnings now but have
the potential to pay off later.

What Does Free Cash Flow Indicate?

Growing free cash flows are frequently a prelude to increased
earnings. Companies that experience surging FCF - due to revenue
growth, efficiency improvements, cost reductions, share buy backs,
dividend distributions or debt elimination - can reward investors
tomorrow. That is why many in the investment community cherish
FCF as a measure of value. When a firm's share price is low and free
cash flow is on the rise, the odds are good that earnings and share
value will soon be on the up.

By contrast, shrinking FCF signals trouble ahead. In the absence of

decent free cash flow, companies are unable to sustain earnings
growth. An insufficient FCF for earnings growth can force a company
to boost its debt levels. Even worse, a company without enough FCF
may not have the liquidity to stay in business.

Is Free Cash Flow Foolproof?

Although it provides a wealth of valuable information that investors
really appreciate, FCF is not infallible. Crafty companies still have
leeway when it comes to accounting sleight of hand.
Without a regulatory standard for determining FCF, investors often
disagree on exactly which items should and should not be treated as
capital expenditures. Investors must therefore keep an eye on
companies with high levels of FCF to see if these companies are
under-reporting capital expenditure and R&D. Companies can also
temporarily boost FCF by stretching out their payments, tightening
payment collection policies and depleting inventories. These activities
diminish current liabilities and changes to working capital. But the
impacts are likely to be temporary.

The Trick of Hiding Receivables

Let's look at yet another example of FCF tomfoolery, which involves
specious calculations of the current accounts receivable. When a
company reports revenue, it records an account receivable, which
represents cash that is yet to be received. The revenues then
increase net income and cash from operations, but that increase is
typically offset by an increase in current accounts receivable, which
are then subtracted from cash from operations. When companies
record their revenues as such, the net impact on cash from
operations and free cash flow should be zero since no cash has
been received.
What happens when a company decides to record the revenue, even
though the cash will not be received within a year? The receivable for
a delayed cash settlement is therefore "non-current" and can get
buried in another category like "other investments". Revenue then is
still recorded and cash from operations increases, but no current
account receivable is recorded to offset revenues. Thus, cash from
operations and free cash flow enjoy a big but unjustified boost. Tricks
like this one can be hard to catch.
Conclusion
Alas, finding an all-purpose tool for testing company fundamentals
still proves elusive. Like all performance metrics, FCF has its limits.
On the other hand, provided that investors keep their guard up, free
cash flow is a very good place to start hunting.

by Ben McClure, (Contact Author | Biography)

Ben is director of McClure & Co., an independent research and
consulting firm that specializes in investment analysis and
intelligence. Before founding McClure & Co., Ben was a highly-rated
European equities analyst at London-based Old Mutual Securities.

Terminology:-

1.Cash Flow

What Does Cash Flow Mean?

1. A revenue or expense stream that changes a cash account over a given
period. Cash inflows usually arise from one of three activities - financing,
operations or investing - although this also occurs as a result of donations or
gifts in the case of personal finance. Cash outflows result from expenses
or investments. This holds true for both business and personal finance.

2. An accounting statement called the "statement of cash flows", which shows

the amount of cash generated and used by a company in a given period. It is
calculated by adding noncash charges (such as depreciation) to net income
after taxes. Cash flow can be attributed to a specific project, or to a business
as a whole. Cash flow can be used as an indication of a company's financial
strength.

Investopedia explains Cash Flow

1. In business as in personal finance, cash flows are essential to solvency.
They can be presented as a record of something that has happened in the past,
such as the sale of a particular product, or forecasted into the future,
representing what a business or a person expects to take in and to spend.
Cash flow is crucial to an entity's survival. Having ample cash on hand will
ensure that creditors, employees and others can be paid on time. If a business
or person does not have enough cash to support its operations, it is said to be
insolvent, and a likely candidate for bankruptcy should the insolvency
continue.
2. The statement of a business's cash flows is often used by analysts to gauge
financial performance. Companies with ample cash on hand are able to invest
the cash back into the business in order to generate more cash and profit.

2.Free Cash Flow - FCF

What Does Free Cash Flow - FCF Mean?

A measure of financial performance calculated as operating cash flow minus
capital expenditures. Free cash flow (FCF) represents the cash that a company
is able to generate after laying out the money required to maintain or expand
its asset base. Free cash flow is important because it allows a company
to pursue opportunities that enhance shareholder value. Without cash, it's
tough to develop new products, make acquisitions, pay dividends and reduce
debt. FCF is calculated as:

It can also be calculated by taking operating cash flow and subtracting capital
expenditures.

Investopedia explains Free Cash Flow - FCF

Some believe that Wall Street focuses myopically on earnings while ignoring
the "real" cash that a firm generates. Earnings can often be clouded by
accounting gimmicks, but it's tougher to fake cash flow. For this reason, some
investors believe that FCF gives a much clearer view of the ability to generate
cash (and thus profits).

It is important to note that negative free cash flow is not bad in itself. If free
cash flow is negative, it could be a sign that a company is making large
investments. If these investments earn a high return, the strategy has the
potential to pay off in the long run.
 3.Dividend

What Does Dividend Mean?

1. A distribution of a portion of a company's earnings, decided by the board of
directors, to a class of its shareholders. The dividend is most often quoted in
terms of the dollar amount each share receives (dividends per share). It can
also be quoted in terms of a percent of the current market price, referred to as
dividend yield.

Also referred to as "Dividend Per Share (DPS)."

2. Mandatory distributions of income and realized capital gains made to

mutual fund investors.

Investopedia explains Dividend

1. Dividends may be in the form of cash, stock or property. Most secure and
stable companies offer dividends to their stockholders. Their share prices
might not move much, but the dividend attempts to make up for this.

High-growth companies rarely offer dividends because all of their profits are
reinvested to help sustain higher-than-average growth.

2. Mutual funds pay out interest and dividend income received from their
portfolio holdings as dividends to fund shareholders. In addition, realized
capital gains from the portfolio's trading activities are generally paid out
(capital gains distribution) as a year-end dividend.

4.Operating Cash Flow - OCF

What Does Operating Cash Flow - OCF Mean?

The cash generated from the operations of a company, generally defined as
revenues less all operating expenses, but calculated through a series of
adjustments to net income. The OCF can be found on the statement of cash
flows.
Also known as "cash flow provided by operations" or "cash flow from
operating activities".

One method of calculated OCF is:

Investopedia explains Operating Cash Flow - OCF

Operating cash flow is the cash that a company generates through running its
business.

It's arguably a better measure of a business's profits than earnings because a

company can show positive net earnings (on the income statement) and still
not be able to pay its debts. It's cash flow that pays the bills!

You can also use OCF as a check on the quality of a company's earnings. If a
firm reports record earnings but negative cash, it may be using aggressive
accounting techniques.

5.Balance Sheet

What Does Balance Sheet Mean?

A financial statement that summarizes a company's assets, liabilities
and shareholders' equity at a specific point in time. These three balance sheet
segments give investors an idea as to what the company owns and owes, as
well as the amount invested by the shareholders.

The balance sheet must follow the following formula:

Assets = Liabilities + Shareholders' Equity

Investopedia explains Balance Sheet

It's called a balance sheet because the two sides balance out. This makes
sense: a company has to pay for all the things it has (assets) by either
borrowing money (liabilities) or getting it from shareholders (shareholders'
equity).

Each of the three segments of the balance sheet will have many accounts
within it that document the value of each. Accounts such as cash, inventory
and property are on the asset side of the balance sheet, while on the liability
side there are accounts such as accounts payable or long-term debt. The exact
accounts on a balance sheet will differ by company and by industry, as there is
no one set template that accurately accommodates for the differences between
different types of businesses.

6.Capital Expenditure - CAPEX

What Does Capital Expenditure - CAPEX Mean?

Funds used by a company to acquire or upgrade physical assets such as
property, industrial buildings or equipment. This type of outlay is made by
companies to maintain or increase the scope of their operations. These
expenditures can include everything from repairing a roof to building a brand
new factory.

Investopedia explains Capital Expenditure - CAPEX

The amount of capital expenditures a company is likely to have depends on
the industry it occupies. Some of the most capital intensive industries include
oil, telecom and utilities.

In terms of accounting, an expense is considered to be a capital expenditure

when the asset is a newly purchased capital asset or an investment that
improves the useful life of an existing capital asset. If an expense is a capital
expenditure, it needs to be capitalized; this requires the company to spread
the cost of the expenditure over the useful life of the asset. If, however, the
expense is one that maintains the asset at its current condition, the cost is
deducted fully in the year of the expense.

7.Net Income - NI

What Does Net Income - NI Mean?

1. A company's total earnings (or profit). Net income is calculated by
taking revenues and adjusting for the cost of doing business, depreciation,
interest, taxes and other expenses. This number is found on a company's
income statement and is an important measure of how profitable the company
is over a period of time. The measure is also used to calculate earnings per
share.
Often referred to as "the bottom line" since net income is listed at the bottom
of the income statement. In the U.K., net income is known as "profit
attributable to shareholders".

2. An individual’s income after deductions, credits and taxes are factored into
gross income. Deductions and credits are subtracted from gross income to
arrive at taxable income, which is used to calculate income tax. Net income is
income tax subtracted from taxable income.

Investopedia explains Net Income - NI

1. Net income is calculated by starting with a company's total revenue. From
this, the cost of sales, along with any other expenses that the company
incurred during the period, is removed to reach earnings before tax. Tax is
deducted from this amount to reach the net income number. Net income, like
other accounting measures, is susceptible to manipulation through such
things as aggressive revenue recognition or by hiding expenses. When basing
an investment decision on net income numbers, it is important to review the
quality of the numbers that were used to arrive at this value.

2. For example, suppose that your gross income is $50,000 and you have
$20,000 in deductions and credits. This leaves you with a taxable income of
$30,000. Then, suppose that another $5,000 of income tax is subtracted; the
remaining $25,000 will be your net income.

8.Depreciation

What Does Depreciation Mean?

1. In accounting, an expense recorded to allocate a tangible asset's cost over
its useful life. Because depreciation is a non-cash expense, it increases free
cash flow while decreasing reported earnings.

2. A decrease in the value of a particular currency relative to other currencies.

Investopedia explains Depreciation

1. Depreciation is used in accounting to try to match the expense of an asset
to the income that the asset helps the company earn. For example, if a
company buys a piece of equipment for $1 million and expects it to have a
useful life of 10 years, it will be depreciated over 10 years. Every accounting
year, the company will expense $100,000 (assuming straight-line
depreciation), which will be matched with the money that the equipment helps
to make each year.

2. Examples of currency depreciation are the infamous Russian ruble crisis in

1998, which saw the ruble lose 25% of its value in one day.

9.Amortization

What Does Amortization Mean?

1. The paying off of debt in regular installments over a period of time.

2. The deduction of capital expenses over a specific period of time (usually

over the asset's life). More specifically, this method measures the
consumption of the value of intangible assets, such as a patent or a copyright.

Investopedia explains Amortization

Suppose XYZ Biotech spent $30 million dollars on a piece of medical
equipment and that the patent on the equipment lasts 15 years, this
would mean that $2 million would be recorded each year as an amortization
expense.

While amortization and depreciation are often used interchangeably,

technically this is an incorrect practice because amortization refers to
intangible assets and depreciation refers to tangible assets.

Amortization can be calculated easily using most modern financial calculators,

spreadsheet software packages such as Microsoft Excel, or amortization charts and tables.

10.Working Capital

What Does Working Capital Mean?

A measure of both a company's efficiency and its short-term financial health.
The working capital ratio is calculated as:

Positive working capital means that the company is able to pay off its short-
term liabilities. Negative working capital means that a company currently is
unable to meet its short-term liabilities with its current assets (cash, accounts
receivable and inventory).

Also known as "net working capital", or the "working capital ratio".

Investopedia explains Working Capital

If a company's current assets do not exceed its current liabilities, then it may
run into trouble paying back creditors in the short term. The worst-case
scenario is bankruptcy. A declining working capital ratio over a longer time
period could also be a red flag that warrants further analysis. For example, it
could be that the company's sales volumes are decreasing and, as a result, its
accounts receivables number continues to get smaller and smaller.

Working capital also gives investors an idea of the company's underlying

operational efficiency. Money that is tied up in inventory or money that
customers still owe to the company cannot be used to pay off any of the
company's obligations. So, if a company is not operating in the most efficient
manner (slow collection), it will show up as an increase in the working capital.
This can be seen by comparing the working capital from one period to
another; slow collection may signal an underlying problem in the company's
operations.

11.Liquidity

What Does Liquidity Mean?

1. The degree to which an asset or security can be bought or sold in the
market without affecting the asset's price. Liquidity is characterized by a high
level of trading activity. Assets that can by easily bought or sold, are known as
liquid assets.

2. The ability to convert an asset to cash quickly. Also known as

"marketability".

There is no specific liquidity formula, however liquidity is often calculated by

using liquidity ratios.

Investopedia explains Liquidity

1. It is safer to invest in liquid assets than illiquid ones because it is easier for
an investor to get his/her money out of the investment.

2. Examples of assets that are easily converted into cash include blue chip and
money market securities.
 12.Research And Development - R&D

What Does Research And Development - R&D Mean?

Investigative activities that a business chooses to conduct with the
intention of making a discovery that can either lead to the development of new
products or procedures, or to improvement of existing products or procedures.
Research and development is one of the means by which business can
experience future growth by developing new products or processes to
improve and expand their operations.

Investopedia explains Research And Development - R&D

While R&D is often thought of as synonymous with high-tech firms that are on
the cutting edge of new technology, many established consumer goods
companies spend large sums of money on improving old products. For
example, Gillette spends quite a bit on R&D each year in ongoing attempts to
design a more effective shaver.

On average, most companies spend only a small percentage of their revenue

on R&D (usually under 5%). However, pharmaceuticals, software
and semiconductor companies tend to spend quite a bit more.

13.Accounts Receivable - AR

What Does Accounts Receivable - AR Mean?

Money owed by customers (individuals or corporations) to another entity in
exchange for goods or services that have been delivered or used, but not yet
paid for. Receivables usually come in the form of operating lines of credit and
are usually due within a relatively short time period, ranging from a few days
to a year.

On a public company's balance sheet, accounts receivable is often recorded

as an asset because this represents a legal obligation for the customer to
remit cash for its short-term debts

Investopedia explains Accounts Receivable - AR

If a company has receivables, this means it has made a sale but has yet to
collect the money from the purchaser. Most companies operate by allowing
some portion of their sales to be on credit. These type of sales are
usually made to frequent or special customers who are invoiced periodically,
and allows them to avoid the hassle of physically making payments as each
transaction occurs. In other words, this is when a customer gives a company
an IOU for goods or services already received or rendered.

Accounts receivable are not limited to businesses - individuals have them as

well. People get receivables from their employers in the form of a monthly or
bi-weekly paycheck. They are legally owed this money for services (work)
already provided.

When a company owes debts to its suppliers or other parties, these are known
as accounts payable.