Free cash flow is the cash a company generates through its operations minus the cost of the assets. In other words, free cash flow or net cash flow is the cash remaining after the payment of operating expenses and capital costs or capital investments.
Free cash flow is one of the most important indicators as it shows how efficient the Company on receipt of funds. Investors use free cash flow to evaluate the company may have enough cash after funding operating and capital costs to pay back investors via dividends and share buybacks.
The Calculation Of Free Cash Flow
To calculate free cash flow from a statement of cash flows, we will find the item cash flow from operations (also referred to as “Operating cash” or “net cash from operating activities”) and subtract the capital expenditure required for current operations.
Free cash flow formula:
Example of free cash flow
Macy’s Inc (M)
The following is the report on movement of funds, Macy’s for the fiscal year ending 2017 for the 10K statement of the company.
Macy recorded the following:
- Cash flow from operating activities = 1.944 billion.
- Capital expenditures of $760 million.
- Macy fki = $1,944 – $760 = $1.184 billion.
Translation Free Cash Flow
We see that Macey was a large amount of free cash flow, which can be used for the payment of dividends, expansion and diversification of its balance sheet, i.e. to reduce the debt.
Please note credit 411 million dollars from the sale of property and equipment listed in the section cash flow from investing activities was not included because it is a one-time event and is not part of the daily activities of the cash flow.
The growth of free cash flows is often a prelude to an increase in profits. Companies growing FCF – due to revenue growth, efficiency gains, cost reductions, share buy backs, dividend distributions or debt elimination – tomorrow can reward investors. That’s why many in the investment community cherish fcf as a measure of value. When the price of the share is low and free cash flow on the rise, chances are good that earnings and share value will soon be to lead.
On the contrary, shy and fcf may indicate that the company is unable to maintain revenue growth. An insufficient FCF for earnings growth can force a company to increase debt levels or may not have the liquidity to stay in business.
To calculate free cash flow another way, you will need the income statement and balance sheet. Start with net income and add back depreciation and amortization. To 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):
– Changes in working capital
– Capital Expenditures
= Free Cash Flow
It may seem strange to return depreciation accounts for capital expenditures. The rationale for the adjustment lies in the fact 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 can eat into earnings but have the potential to pay off later.
One disadvantage of using the method of free cash flow is that capital costs can vary significantly from year to year and between different industries. That is why it is very important to measure free cash flow over several periods and on the background industry of the company.
It is important to note that the extremely high free cash flow can be an indication that the company does not invest in your business properly, such as updating its fixed assets. Conversely, negative free cash flow may not necessarily mean that the company has financial problems, but on the contrary, invests heavily in expanding its market share, which is likely to lead to future growth.
Value investors often look for companies with high or improving cash flow but low share prices. The increase in cash flows is often considered as an indicator that future growth is likely.