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Free Cash Flow (FCF)



Definition

Free Cash Flow (FCF) is a financial term that refers to the cash a company generates after accounting for capital expenditures such as buildings or equipment. This cash can be used for expansion, paying down debt, dividends, or other purposes. Essentially, it’s the money left over after a company has paid off all its operational expenses and investments.

Phonetic

Free Cash Flow (FCF): /fri: kæʃ floʊ/

Key Takeaways

<ol><li>Free Cash Flow (FCF) represents the amount of cash a company has after paying its operating expenses and capital expenditures. It’s a crucial metric to understand a company’s financial health.</li><li>FCF can be used to determine a company’s ability to generate cash that can potentially be distributed to shareholders, fund new business opportunities, or pay off debt. A positive FCF indicates a financially secure and self-sustaining business, while a negative FCF may signal financial troubles.</li><li>FCF can be an important resource when comparing profitability between companies. While earnings can be influenced by various accounting practices, FCF provides a clearer view of company performance and financial strength as it relies on cash flows rather than accruals.</li></ol>

Importance

Free Cash Flow (FCF) is a pivotal financial term in business and finance because it measures a company’s financial performance and the capability to generate cash over and above its operational and capital expenditure. It’s an indication of a company’s financial flexibility and represents the cash that a company can distribute among its shareholders without hindering its growth. Investors and analysts extensively use the FCF for assessing a company’s profitability as it eliminates non-cash expenses and can provide a clearer picture of a company’s ability to fund acquisitions, pay dividends, reduce debt, and reinvest in its own operations. Therefore, a positive FCF signifies a healthy company, whereas a negative FCF generally indicates the opposite.

Explanation

Free Cash Flow (FCF) is a crucial measure for stakeholders, investors and financial analysts as it shows how efficient a company is at generating cash. Companies with ample free cash flow have the ability to pay down debt, pay out dividends, buy back stock, and make valuable acquisitions. Essentially, it provides a snapshot of the company’s financial flexibility and durability, which can be very helpful when comparing companies within the same industry.In addition, FCF is an important figure in assessing a firm’s worth. In valuation models, analysts and investors typically utilize FCF as it provides a more transparent view of the cash available to the company. In other words, Free Cash Flow is used because it tells the truth about how much cash a company is making. It strips out the non-cash items and eliminates the impact of different approaches to capital expenditure, making it easier to compare different companies or projects. In this way, examining the FCF allows companies and investors to focus on the core business operations and their profitability.

Examples

1. Apple Inc.: Apple is known for its significant free cash flow which allows it to invest in research and development as well as acquire other companies. In the fiscal year of 2020, Apple reported a Free Cash Flow of $73.365 billion; financial analysts use this data to evaluate the company’s short and long-term financial strength.2. General Motors Company: GM during the 2008 financial recession, had a negative free cash flow because the expenditures due to manufacturing costs, employees’ salaries as well as interests on loans exceeded the cash that was coming in from sales. Negative FCF indicated GM’s inability to self-sustain, leading it to seek a government bailout to remain solvent.3. Amazon Inc.: Amazon is another company that for many years had shown a low or even negative Free Cash Flow, mainly because it constantly invests in growth and expansion opportunities such as acquisitions, infrastructure, and technology. Despite lower FCF, investors remain confident due to Amazon’s consistent top-line growth and its proven strategy of heavy investing for future profitability. In recent years, as the company has matured and its investments have started to pay off, its free cash flow situation has significantly improved.

Frequently Asked Questions(FAQ)

What is Free Cash Flow (FCF)?

Free Cash Flow (FCF) is a financial performance measurement that shows how much cash a company generates after accounting for capital expenditures. It’s an important metric because it allows a company to pursue opportunities that enhance shareholder value.

How is Free Cash Flow calculated?

Free Cash Flow is calculated by subtracting capital expenditures from operating cash flow. The formula is: FCF = Operating Cash Flow – Capital Expenditures.

Why is Free Cash Flow important?

Free Cash Flow is important because it shows the true profitability of a company. It shows how much cash is left over after necessary investments in the business, giving a clear picture of the company’s financial health and its ability to fund growth, pay dividends, or reduce debt.

What does negative Free Cash Flow indicate?

A negative Free Cash Flow indicates that a company is spending more cash than it’s generating. This could be due to high capital expenditures, decrease in sales revenue, or increase in costs. A consistent negative FCF may indicate financial troubles.

What does positive Free Cash Flow indicate?

A positive Free Cash Flow indicates that a company is generating more cash than it’s spending. This excess cash can be used for expanding operations, pay dividends to shareholders or pay off debt.

Is a high Free Cash Flow always a good sign?

Generally, a high Free Cash Flow is a good sign as it signifies the company is generating enough cash to support operations and shareholder returns. However, it can also indicate underinvestment in the business which could harm the long-term growth.

Can Free Cash Flow be manipulated?

While it’s more difficult to manipulate cash-based metrics like Free Cash Flow compared to accrual-based metrics, it’s not impossible. Factors such as changes in working capital policies, delaying or accelerating capital expenditures can temporarily affect FCF.

How does Free Cash Flow differ from Operating Cash Flow?

Operating Cash Flow is the cash generated from a company’s normal business operations. Free Cash Flow, on the other hand, is what remains after subtracting capital expenditures necessary to maintain or expand the business from operating cash flow. So, FCF presents a clearer picture of a company’s flexibility and financial viability.

Related Finance Terms

  • Operating Cash Flow
  • Capital Expenditure
  • Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)
  • Net Income
  • Working Capital

Sources for More Information


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