Understanding Free Cash Flow (FCF)

Free cash flow is a valuation multiple that many investors use to determine the health of a particular company. This metric can provide investors with valuable information about a company concerning whether they should invest in it. Here are the basics of free cash flow and how it can be used by investors.

Free Cash Flow

Free cash flow is a measurement that signifies how much cash a company has left over after paying for its asset base. This essentially means that the money can be used for other purposes, such as increasing shareholder equity. When you are investing in a company, it is good to see a large amount of free cash flow available. This tells you that the company is not having any trouble paying the bills and that they can focus on growing the company instead. The more free cash flow that is present, the healthier a company is. 

How to Calculate

To calculate free cash flow you are going to need the company's cash flow statement or income statement and the balance sheet. Once you have the cash flow statement, you will need to identify the cash flow from operations category. You will then need to subtract capital expenditures from that amount. This will tell you the amount of free cash flow for the company.

You can also calculate it by using the income statement and the balance sheet. Start out by identifying the net income for the business. Add to that number the amount of depreciation and amortization. You will then need to subtract the change in working capital and capital expenditures from that number. If you need to calculate the change in working capital, you can take the current liabilities and subtract them from the current assets.

How it is Used

Investors use free cash flow to determine if a company is about to increase their earnings. Typically, when a company is about to go through a period of increased earnings, the free cash flow is going to rise. This is typically a good indicator of when to get involved with a particular stock. If the free cash flow increases, you know that there is a good chance that the company is about to grow.

Problems

Even though this method can be beneficial, it is definitely not foolproof. As with any valuation multiples, there are some inherent problems that you will have to be aware of. For one thing, there is not a specific rule when it comes to what is included in capital expenditures. Therefore, one investor is going to count one expense and another investor will not. This means that free cash flow will be different from one investor's calculation to another.

Companies can also manipulate these numbers by doing a variety of different things. They could potentially spread out their debt payments in order to improve the free cash flow. They could also affect it by lowering inventory.

This means that even though it can be a good tool, you do not want to put too much emphasis on it.

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