Usually abbreviated as FCF, the Free Cash Flow is an efficiency as well as a liquidity ratio. It calculates how much money a company is able to generate, compared to its costs of running and expansion.
As you might have guessed it, the free cash flow means the money that a company produces in excess, as profit, after it has paid its CAPEX and all of its operating expenses.
Of course, this ratio is quite important – it shows the effectiveness of a company in terms of generating money. Moreover, if a company is very efficient when it comes to what we’ve just mentioned, then it is likely that investors will target it. Why?
Because the investors will be sure that, after a certain company has paid and funded its expansions and operations, the company still has enough funds, or free cash flow, to pay the said investors a return – and this aspect is looked for by many of them, as most of them don’t want to risk an investment.
The Basics of Free Cash Flow
Some of the other financial ratios out there have ways through which they can be adjusted, and therefore show fake results. This is made by the management, as the team tempers with the accounting principles in order to adjust or change a certain financial ratio.
However, when it comes to free cash flow, this can’t be changed or altered, and this is why investors like using this measurement a lot – it shows the truth; it shows exactly how a company stands and if the business is indeed profitable or not.
Of course, faking the cash flow of a company is quite difficult. Therefore, the investors that have their eyes on a certain company will know exactly if it’s worth investing in and if it will be able to return their investment.
Creditors use this financial ratio as well. However, they use it in order to determine if a certain company is able to pay off its debt and so on.
The Formula of Free Cash Flow
To come up with the free cash flow of a certain company, one must subtract the capital expenditures from the operating cash flow. The latter can be calculated by subtracting any
change in the net working capital and taxes from the EBITDA.
The equation is as simple as it gets, and the result speaks for itself – it shows how much money the company will have available after it pays off its fixed asset purchases and operations.
Naturally, a higher free cash flow means that a company is doing well, as all of its activities can be safely funded, while the extra money can go to investors. However, keep in mind that a high FCF can hide some unpleasant facts.
For example, a company might be able to maintain a high free cash flow ratio just because it isn’t buying any new equipment or upgrades that would further benefit the company. In time, their current equipment will deteriorate and, when the time comes, the company will be forced to replace it.
This means that the company is almost always on the verge of stopping its business – even if it has a high free cash flow.