Free Cash Flow

What is Free Cash Flow ?

Free cash flow is the cash flow that a company generates after accounting for its capital expenditures, or investments in fixed assets like property, plant, and equipment. It represents the cash available for the company to use for other purposes, such as paying dividends, repaying debt, or pursuing growth opportunities.

How is free cash flow calculated?

Free cash flow is a critical financial metric that provides valuable insights into a company's financial health and ability to generate cash. At its core, free cash flow represents the amount of cash a company generates after accounting for all of its capital expenditures. 

To calculate free cash flow, one must subtract capital expenditures from operating cash flow. Operating cash flow is the cash generated from a company's operations and can be found on the cash flow statement. Capital expenditures, on the other hand, represent the cash outflows a company incurs to acquire or improve its fixed assets, such as property, plant, and equipment. By subtracting capital expenditures from operating cash flow, we arrive at the free cash flow, which can be used to invest in growth opportunities, pay dividends, or reduce debt. 

 Free cash flow = Operating cash flow - Capital expenditures.

Why is free cash flow important?

There are several reasons why free cash flow is considered an important metric.

Firstly, free cash flow provides insights into a company's financial health and ability to generate cash. By subtracting capital expenditures from operating cash flow, we arrive at the free cash flow, which can reveal whether a company is generating enough cash to fund its operations and investments without the need for external financing.

Secondly, free cash flow can be used to evaluate a company's ability to pay dividends and reduce debt. If a company generates substantial free cash flow, it may have the flexibility to pay regular dividends to shareholders or reduce its debt load, which can improve its financial position and potentially boost its stock price.

Lastly, free cash flow can be used to assess a company's growth prospects. By reinvesting free cash flow back into the business, a company can pursue growth opportunities, such as new product development, geographic expansion, or acquisitions. In this way, free cash flow can be a valuable indicator of a company's ability to create long-term value for shareholders.

Examples of free cash flow

Here are some examples of free cash flow:

• Cash from operations: Free cash flow can be generated from the cash flow from operating activities, which includes cash received from customers, less cash paid to suppliers and employees, and taxes paid.
• Working capital: An organization can improve its free cash flow by managing its working capital effectively. 
• Dividends paid: If an organization has sufficient free cash flow, it may choose to pay dividends to shareholders as a way to return value to investors.
• Share buybacks: Another way that an organization can use its free cash flow is to buy back shares of its own stock. This can help to increase the value of remaining shares and improve earnings per share.

Benefits of free cash flow

Here are some benefits of free cash flow:

• Evaluating financial health: Free cash flow can be used to evaluate a company's financial health and its ability to generate cash from its operations after accounting for capital expenditures.
• Assessing growth potential: By measuring a company's ability to invest in new projects, make strategic acquisitions, or return cash to shareholders through dividends or share repurchases, free cash flow can be used to assess its growth potential.
• Supporting investment decisions: As part of evaluating new projects or comparing company valuations, free cash flow can be used to support investment decisions.