The way a company’s executives choose to apply free cash flow is telling.
Abundant FCF allows companies to exert high levels of financial influence even after they’ve attended to operational upkeep, necessary capital investments, and dividend payouts for stockholders. The liquidity of cash makes it a unique asset, and a necessary one for businesses seeking to pursue aggressive horizontal or vertical integrations, often by way of acquiring smaller companies.
In addition to using FCF to expand a corporate empire, executives may choose a more conservative application by using FCF to shore up the business’s financial position through the amassment of savings, the buying back of stock, or the paying down of debt.
In any case, the point is that a company’s free cash flow represents cash that is not otherwise spoken for.
Calculating Free Cash Flow
The most common formula for calculating cash flow is as follows:
Net Cash Flow from Operations – Capital Expenditure – Cash Dividends = Free Cash Flow
Net Cash Flow from Operations
A company’s net cash flow from operations is the amount of income that is produced from normal operating activities. This value includes the operating expenses that are incurred to generate that revenue such as sales expenses or the cost of materials and supplies used in manufacturing.
On a company’s statement of cash flows, the net cash flow from operations is usually in the topline section of the statement.
Capital expenditures are those investing activities that are related to PPE—property, plant, or equipment. These are costs that directly support the sustainability of essential operations but are not considered a cost of sales.
Remember: the cost to generate revenues from operations have already been deducted before we are calculating FCF.
Cash dividends are the payments that companies make to their shareholders. They are included in the free cash flow calculation because companies are often under significant pressure to keep their dividend payments above certain thresholds.
Once these obligations—capital expenditures and cash dividends—have been deducted from the net cash flow from operations, the remainder (FCF) can be used for growth activities.
Why Free Cash Flow?
Why bother calculating free cash flow at all? Can’t investors make smart decisions about the profitability of companies based on the content of their income statements?
While it is true that a company’s stated income paints a picture of the amount of money they are bringing in, the issue is that it doesn’t tell the whole story.
The free cash flow calculation tells investors what a company’s cash situation is in the here and now. Conversely, an income statement spreads the cash spent on large investments or purchases out over time. In many cases the cost spike associated with a large purchase, a million-dollar computer system for example, is spread out over a number of years as depreciation on an income statement.
While that representation may be useful for accounting and tax purposes, it doesn’t help investors understand the amount of cash a company has on hand to spend on growth activities right now. The FCF calculation provides exactly that information.
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