What is What is a good free cash flow?

Free Cash Flow: The Lifeblood of a Healthy Business

Free cash flow (FCF) is a crucial financial metric that represents the cash a company generates after accounting for cash outflows to support its operations and maintain its capital assets. It's the cash available to the company for discretionary uses like paying dividends, buying back shares, making acquisitions, or paying down debt. Understanding FCF is paramount for investors and finance professionals alike because it provides a clear picture of a company's financial health and its ability to generate value for shareholders.

While the concept of cash flow has always been important, the specific metric of "free cash flow" gained prominence in the 1980s and 1990s, largely thanks to influential investors and analysts like Alfred Rappaport. Rappaport emphasized that shareholder value is ultimately driven by a company's ability to generate cash, and FCF became a key indicator of this ability. Before FCF's widespread adoption, metrics like net income were often used, but these are susceptible to accounting manipulations and don't necessarily reflect the actual cash a company has available. FCF provides a more objective and reliable view.

A healthy, positive FCF indicates a company is generating more cash than it's spending on maintaining and growing its business. This excess cash provides flexibility and allows the company to pursue various value-creating activities. Conversely, a negative FCF suggests a company is spending more cash than it's generating, potentially indicating financial distress or a need to raise capital. Therefore, FCF serves as a critical early warning sign for potential problems.

Deconstructing Free Cash Flow: A Closer Look

Understanding what constitutes a "good" free cash flow requires understanding how it's calculated. Several methods exist, but the most common approach starts with net income and adjusts for non-cash expenses and changes in working capital. Here's a breakdown:

• Starting Point: Net Income: This is the profit a company reports on its income statement. However, net income includes non-cash items like depreciation and amortization, which need to be adjusted for in FCF calculations.

• Adding Back Non-Cash Expenses: Depreciation and amortization are expenses that reduce net income but don't involve an actual cash outflow. These are added back to net income to arrive at a more accurate cash flow figure. Other non-cash items, such as stock-based compensation and deferred taxes, may also be added back.

• Adjusting for Changes in Working Capital: Working capital represents the difference between a company's current assets (like accounts receivable and inventory) and its current liabilities (like accounts payable). Changes in working capital can significantly impact a company's cash flow.

  • Increase in Accounts Receivable: If a company sells goods on credit (accounts receivable) but hasn't yet received cash payment, this represents a use of cash. An increase in accounts receivable reduces FCF.
  • Increase in Inventory: An increase in inventory represents a use of cash as the company has spent money to acquire the inventory. An increase in inventory reduces FCF.
  • Increase in Accounts Payable: If a company purchases goods on credit (accounts payable) but hasn't yet paid for them, this represents a source of cash. An increase in accounts payable increases FCF.

• Subtracting Capital Expenditures (CAPEX): CAPEX represents the money a company spends on acquiring or upgrading fixed assets like property, plant, and equipment (PP&E). These are essential investments for maintaining and growing the business, and they represent a significant cash outflow. CAPEX is subtracted from the adjusted net income figure.

Formula Summary:

FCF = Net Income + Non-Cash Expenses - Changes in Working Capital - Capital Expenditures (CAPEX)

Another common approach is to start with cash flow from operations (CFO) and subtract CAPEX:

FCF = Cash Flow from Operations (CFO) - Capital Expenditures (CAPEX)

Both formulas should arrive at a similar FCF number.

It's important to note that there's no single, universally accepted definition of FCF. Some analysts use different variations, such as "levered FCF" (FCFE), which represents the cash flow available to equity holders after debt obligations are met. Understanding the specific definition being used is crucial when comparing FCF across different companies or periods.

Real-World Applications of Free Cash Flow

Consider two hypothetical companies: TechCorp and OldCo.

• TechCorp: A rapidly growing technology company. TechCorp reports strong revenue growth and increasing net income. However, it also has significant capital expenditures to support its expansion, and its working capital is increasing as it sells more products on credit. Despite the strong revenue growth, TechCorp's FCF is only marginally positive.

• OldCo: A mature manufacturing company. OldCo's revenue growth is modest, and its net income is stable. However, OldCo's capital expenditures are relatively low, and it efficiently manages its working capital. As a result, OldCo generates a substantial amount of FCF.

While TechCorp might appear more attractive based on its revenue growth, OldCo's strong FCF might make it a more appealing investment. OldCo can use its FCF to pay dividends, buy back shares, or make strategic acquisitions, all of which can create value for shareholders. TechCorp, on the other hand, may need to raise capital to fund its growth, which could dilute existing shareholders.

Another example is analyzing companies during economic downturns. Companies with strong FCF positions are better equipped to weather economic storms than those with weak or negative FCF. During a recession, companies may experience a decline in revenue and profits. However, companies with ample FCF can continue to invest in their business, pay down debt, and even acquire competitors.

Why Free Cash Flow Matters to Investors

FCF is a powerful tool for investors because it provides insights into a company's:

• Financial Health: A consistently positive FCF signals a healthy business that is generating more cash than it is spending.

• Financial Flexibility: Strong FCF provides the company with the flexibility to pursue various value-creating activities, such as paying dividends, buying back shares, and making acquisitions.

• Valuation: FCF can be used to value a company using discounted cash flow (DCF) analysis. DCF analysis involves projecting a company's future FCF and discounting it back to the present to arrive at an estimated intrinsic value.

• Debt Management: Companies with strong FCF are better able to service their debt obligations.

• Growth Potential: While high CAPEX can depress current FCF, it can also indicate investments in future growth. Investors need to consider the context when interpreting CAPEX and its impact on FCF.

What constitutes a "good" FCF? There is no magic number. It depends on the industry, the company's stage of development, and its growth strategy. However, here are some general guidelines:

• Positive FCF is generally desirable. A consistently positive FCF indicates a healthy business.
• Compare FCF to revenue. A higher FCF margin (FCF/Revenue) indicates greater efficiency in generating cash from sales.
• Compare FCF to competitors. Benchmarking FCF against competitors provides valuable insights into a company's relative financial performance.
• Analyze the trend in FCF. A consistently growing FCF is a positive sign.
• Consider the context. A company in a capital-intensive industry may have lower FCF margins than a company in a service-based industry.

Conclusion: Embracing the Power of Free Cash Flow

Free cash flow is a vital metric for assessing a company's financial health and its ability to generate value for shareholders. It provides a more accurate picture of a company's cash-generating capabilities than traditional metrics like net income. By understanding how FCF is calculated and how it can be used to analyze companies, investors can make more informed investment decisions. Remember to consider the industry, the company's stage of development, and its growth strategy when interpreting FCF. While no single FCF number defines a "good" company, consistently positive and growing FCF, compared to peers and analyzed in context, is a strong indicator of a financially sound and potentially rewarding investment. Mastering the concept of FCF is an essential step towards becoming a more sophisticated and successful investor.