Meaning and Definition of Free Cash Flow Formula

It is a great way to build a corpus by investing your money in the stock market. You need to consider many factors when choosing a company to invest your money in. You must evaluate the company on several parameters, such as its ability pay dividends, reduce debt, buy back stock, and facilitate business growth. These parameters will almost always indicate a company's ability to generate sufficient free cash flow, or FCF. What exactly is free cash flow and how can you assess it when researching about a company. This is all you need to know regarding FCF.

Free cash Flow - Definition and Meaning

The company's excess cash flow, also known as free cash flow, is the amount of cash that it can generate after paying the required sums to support operations. This is the excess cash a company has left over after meeting its capital expenditures and expanding its asset base. It is the sum of all money that is available to shareholders and company investors.

How it differs from company earnings

It is important to understand the difference between cash flow and company earnings. Cash does not always equal income. A company earning money does not necessarily mean it can spend its earnings. Only companies can spend "free cash". It is important to know the differences between 'cash' (or cash which you can take out the business) and 'cash that you can spend on the business.

Cash from operations refers to the cash generated by company operations. As business owners are well aware, it's not possible to withdraw all of the cash from operations for business purposes. Companies may require some of the cash to continue running their operations. They need cash to finance capital expenditures or CAPEX. Free cash flow, on the other hand, is the amount of cash that a company can generate after it has spent the necessary sums to remain in business. After deducting all operating expenses, investment costs, and other expenses, it is the cash left at the end of the financial year. FCF stands for the cash that the company can distribute to its equity and debt stakeholder.

Calculating free cash flow

Stock exchanges do not require companies to disclose details about their cash flow. Investors are not able to access information about the FCF of companies listed on stock exchanges. Many companies don't even publish information about FCF in their annual financial statements. However, it is possible to calculate the FCF in two ways. These are the following:

1. Through balance sheet and income statement

First, you need to look at the income statement and balance sheets of the stock to determine its free cash flow. These details are available in the annual financial statements and on the websites of companies that offer the stock. Below is the first formula for free cash flow:

FCF = EBIT (1 tax rate) + (depreciation, amortisation), - (changes in net working capital), - (capital spending)

2. In the company's cashflow statement

The company's regular cashflow statement can be used to calculate the free cash flow. Details are available in their financial reports. The formula can be found below.

FCF = Cashflow from operating activities - capital expenses

This method is becoming more popular and, as you can see, it is very simple.

Significance of Free Cash Flow

Let's now understand the significance of free cash flow.

It is crucial that investors carefully examine the free cash flow of companies they have invested in. This is the best way to determine if the companies are more profitable than their earnings. Earnings only show the company's current profitability, while the company's free cash flow indicates its future growth prospects. The company's excess cash allows it to pursue opportunities that will lead to growth and increase its shareholder value. It reflects the ease with which a company grows and pays dividends to shareholders and investors. The surplus cash can be used by companies to expand their operations, portfolio, create new products or even acquire other businesses.

Analyzing free cash flow - What you need to know

You should not only know what FCF means, but also how to analyze it. It is important to find out where and how cash is coming in when analyzing and calculating a company’s free cash flow. The company could be making money from its earnings, or by taking on debts. It is a good sign if the cash flow has increased because of earnings. However, it may be a red flag if the cash flow has increased because of debts. You should also not assume the prospects of the two companies if their cash flow is identical. Keep in mind that some industries require more capital than others. This is why they might have higher capital expenditure. If you find that capital expenditure is high, it is important to determine the cause. This could be expenses related to growth or general spending. These aspects will help you understand cash flow systems and how to analyze them.

Conclusion

FCF is an integral part of any business. Now you are familiar with it. As a potential stakeholder, it is something you should be aware of before purchasing stock in a company. You can also use financial statements to determine how long you plan on investing in a company. If you depend on dividends for steady income, it is important to make sure that the company that you invest in is financially sound and capable of generating free cash flow, dividends, and other benefits.