Knowing the different technical terms is important when you want to get into finance. Free cash flow is one of the most important terms in this field. In this article, we explain what free cash flow is and how important it is in finance.
What is free cash flow?
Free cash flow (FCF) measures the financial performance of a company. It shows how much cash a company can generate after deducting the purchase of assets such as property, equipment and other major investments from its operating cash flow. In other words, the CWF measures a company’s ability to produce what investors are most interested in. In particular, that available cash is distributed on a discretionary basis.
How important is free cash flow?
Knowing a company’s free cash flow enables management to decide on future businesses that would enhance shareholder value. In addition, having an abundant FCF indicates that a company is able to pay its monthly contributions. Companies can also use their FCF to expand their business activities or pursue other short-term investments. In relation to profit per se, free cash flow is more transparent to show the company’s potential to generate capital and profits. Meanwhile, other entities looking to invest are likely to consider companies that have healthy free cash flow because of a promising future. Add to this a low share price, and investors can generally make good investments with companies that have a high FCF. Other investors highly value the FCF relative to other measures, as it also serves as an important basis for pricing shares.
How is free cash flow calculated?
There are different ways to calculate for FCF, although they should all yield the same results. The formula below is a simple and most commonly used formula for leveraged free cash flow: Free cash flow = Operating cash flow – Capital expenditure
Most of the information needed to calculate a company’s FCF can be found in the cash flow statement. For example, let Company A have $22 million of cash from its business operations and $6.5 million for capital expenditures, net of changes in working capital. Corporation A’s FCF is then calculated as: FCF = $22 – $6.5 = $15.5 million.