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INVESTING FINANCIAL ANALYSIS

Free Cash Flow (FCF)

REVIEWED BY JOHN JAGERSON

Updated May 20, 2019

What is Free Cash Flow?
Free cash flow represents the cash a company generates after cash outflows to support
operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a
measure of profitability that excludes the non-cash expenses of the income statement and
includes spending on equipment and assets as well as changes in working capital.

Interest payments are excluded from the generally accepted definition of free cash flow.
Investment bankers and analysts who need to evaluate a company’s expected performance
with different capital structures will use variations of free cash flow like free cash flow for
the firm and free cash flow to equity, which are adjusted for interest payments and
borrowings.

Similar to sales and earnings, free cash flow is often evaluated on a per share basis to
evaluate the effect of dilution.

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Understanding Free Cash Flow

Why Free Cash Flow Is Used

Free cash flow is the cash flow available to all the investors in a company, including common
stockholders, preferred shareholders, and lenders. Some investors prefer FCF or FCF per
share over earnings and earnings per share as a measure of profitability. However, because
FCF accounts for investments in property, plant, and equipment it can be lumpy and uneven
over time.

Imagine a company has earnings before depreciation, amortization, interest, and taxes
(EBITDA) of $1,000,000 in a given year. Also, assume that this company has had no changes
in working capital (current assets – current liabilities) but they bought new equipment worth
$800,000 at the end of the year. The expense of the new equipment will be spread out over
time on the income statement, which evens out the impact on earnings.

However, because FCF accounts for new equipment all at once, the company will report
$200,000 FCF ($1,000,000 EBITDA - $800,000 Equipment) on $1,000,000 of EBITDA that
year. If we assume that everything else remains the same and there are no further equipment
purchases, EBITDA and FCF will be equal again the next year. In this situation, an investor
will have to determine why FCF dipped so quickly one year only to return to previous levels,
and if that change is likely to continue.

Free Cash Flow (FCF) in Company Analysis

Because FCF accounts for changes in working capital, it can provide important insights into
the value of a company and the health of its fundamental trends. For example, a decrease
in accounts payable (outflow) could mean that vendors are requiring faster payment. A
decrease in accounts receivable (inflow) means the company is collecting from its clients
more quickly. An increase in inventory (outflow) could indicate a building stockpile of
unsold products. Including working capital in a measure of profitability provides an insight
that is missing from the income statement.

For example, assume that a company had made $50,000,000 per year in net income each year
for the last decade. On the surface, that seems stable but what if FCF has been dropping over
the last two years as inventories were rising (outflow), customers started to delay payments
(outflow) and vendors began demanding faster payments (outflow) from the firm? In this
situation, FCF would reveal a serious financial weakness that wouldn’t have been apparent
from an examination of the income statement alone.

FCF is also helpful as the starting place for potential shareholders or lenders to evaluate how
likely the company will be able to pay their expected dividends or interest. If the company’s
debt payments are deducted from FCF (Free Cash Flow to the Firm), a lender would have a
better idea for the quality of cash flows available for additional borrowings. Similarly,
shareholders can use FCF-interest payments to think about the expected stability of future
dividend payments.

Free Cash Flow (FCF) Calculations

FCF can be calculated by starting with Cash Flows from Operating Activities on
the Statement of Cash Flows because this number will have already adjusted earnings for
interest payments, non-cash expenses, and changes in working capital.

The income statement and balance sheet can also be used to calculate FCF.

Other factors from the income statement, balance sheet and statement of cash flows can be
used to arrive at the same calculation. For example, if EBIT was not given, an investor could
arrive at the correct calculation in the following way.

While FCF is a useful tool, it is not subject to the same financial disclosure requirements as
other line items in the financial statements. This is unfortunate because if you adjust for the
fact that CAPEX can make the metric a little “lumpy,” FCF is a good double-check on a
company’s reported profitability. Although the effort is worth it, not all investors have the
background knowledge or are willing to dedicate the time to calculate the number manually.

How To Define “Good” Free Cash Flow - FCF

Fortunately, most financial websites will provide a summary of FCF or a graph of FCF’s
trend for most public companies. However, the real challenge remains: what constitutes good
Free Cash Flow? Many companies with very positive Free Cash Flow will have miserable
stock trends, and the opposite can also be true.

Using the trend of FCF can help you simplify your analysis.

A concept we can borrow from technical analysts or chartists is to focus on the trend of
fundamental performance rather than the absolute values of FCF, earnings, or revenue. If
stock prices are a function of the underlying fundamentals, then a positive FCF trend should
be correlated with positive stock price trends on average.

A common approach is to use the stability of FCF trends as a measure of risk. If the trend of
FCF is stable over the last four to five years, then bullish trends in the stock are less likely to
be disrupted in the future. However, falling FCF trends, especially FCF trends that are very
different compared to earnings and sales trends, indicate a higher likelihood of negative price
performance.

This approach ignores the absolute value of FCF to focus on the slope of FCF and its
relationship to price performance. Consider the following example:

What would you conclude about a stock’s likely price trend with diverging fundamental
performance?

Based on these trends, an investor would be on alert that something may not be going well
with the company, but that the issues haven’t made it to the so-called “headline
numbers” – revenue and earnings per share (EPS). What could cause these issues?

Investing in Growth

A company could have diverging trends like these because management is investing in
property, plant, and equipment to grow the business. In the previous example, an investor
could detect that this is the case by looking to see if CAPEX was becoming larger in 2016-
2018. If FCF + CAPEX were still upwardly trending, this scenario could be a good thing for
the stock’s value.

Stockpiling Inventory

Between 2015 and 2016, Deckers Outdoor Corp (DECK), famous for their UGG boots, grew
sales by a little more than 3%. However, inventory grew by more than 26%, which caused
FCF to fall that year even though revenue was rising. Using this information, an investor may
have wanted to investigate whether DECK would be able to resolve their inventory issues or
if the UGG boot was simply falling out of fashion, before making an investment with the
potential for extra risk.

Credit Problems

A change in working capital can be caused by inventory or a shift in accounts payable and
receivable. If a company’s sales are struggling so they extend more generous payment terms
to their clients, accounts receivable will rise, which is a negative adjustment to FCF.
Alternatively, perhaps a company’s suppliers are not willing to extend credit as generously
and require faster payment. That will reduce accounts payable, which is also a negative
adjustment to FCF.

From 2009 through 2015 many solar companies were dealing with this exact kind of credit
problem. Sales and income could be inflated by offering more generous terms to clients.
However, because this issue was widely known in the industry, suppliers were less willing to
extend terms and wanted to be paid by solar companies faster. In this situation, the
divergence between the fundamental trends was apparent in FCF but not immediately
obvious by just examining the income statement alone.

Summary
Free Cash Flow reconciles net income by adjusting for non-cash expenses, changes in
working capital, and capital expenditures (CAPEX). As a measure of profitability, it is more
uneven than net income but can reveal problems in the fundamentals before they arise on the
income statement.

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Related Terms

Free Cash Flow Per Share

On a per share basis, free cash flow per share is cash available after operating expenses and
CAPEX that can be distributed to debt and equity.
more
What Unlevered Free Cash Flow (UFCF) Reveals
Unlevered free cash flow (UFCF) is a company's cash flow before interest payments are
taken into account. UFCF can be reported in a company's financial statements or calculated
using financial statements by analysts.
more
What Free Cash Flow to the Firm Tells Us
Free cash flow to the firm (FCFF) represents the amount of cash flow from operations
available for distribution after certain expenses are paid.
more
Non-Operating Cash Flows
Non-operating cash flows are inflows and outflows of cash that are not related to the day-to-
day, ongoing operations of a business.
more
Free Cash Flow-To-Sales
Free cash flow-to-sales is a performance ratio that measures operating cash flows after
deduction of capital expenditures relative to sales.
more
Cash Flow From Operating Activities (CFO)
Cash Flow From Operating Activities (CFO) nindicates the amount of cash a company
generates from its ongoing, regular business activities.
more
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