Introduction to Free Cash Flow | LECTURE 21 | FSA | Syeda Arooj Naz

Financial Statement Analysis and Valuation by Syeda Arooj Naz Introduction to Free Cash Flow LECTURE #21 # Syeda Arooj Naz Free Cash Flow The free cash flow calculation refers to how much money a business has left over after it has paid for everything it needs to continue operating—including buildings, equipment, payroll, taxes, and inventory. The company is free to use these funds, it lets business owners know how much money they have to spend at their discretion. It's a key indicator of a company's financial health and desirability to investors. Businesses calculate free cash flow to guide key business decisions, such as whether to expand or invest in ways to reduce operating costs. Investors use Because free cash flow is made up of a variety of components in the financial statement, understanding its composition can provide investors with a lot of useful information. its suppliers faster. If accounts receivable were decreasing, it would mean that a company is receiving payments from its customers faster. Now, if accounts payable was decreasing because suppliers wanted to be paid quicker but accounts receivable was increasing because customers weren't paying quickly enough, this could result in decreased free cash flow, since money is not coming in quickly enough to meet the money going out, which could result in problems for the company down the line. # Benefits of Free Cash Flow Of course, the higher the free cash flow the better. But low free cash flow is not always indicative of a failing business. Even healthy companies see a dip in free cash flow when they're actively pursuing growth. Corporate moves like acquisitions and investments in new product development temporarily subtract from the bottom line. A company with falling or consistently low free cash flow might need to restructure because there's little money remaining after covering the bills. Remember that older, more established companies tend to have more consistent free cash flow, while new businesses are typically in a position where they're pouring money into stabilization and growth. The company's industry also plays a large role in determining free cash flow—not every business needs to spend money on equipment, land, or inventory. The overall benefits of a high free cash flow, however, mean that a company is able to pay its debts, contribute to growth, share its success with its shareholders through dividends, and has prospects for a successful future. # Limitations of Free Cash Flow Though more foolproof than some other calculations, free cash flow is not completely immune to accounting trickery. Regulatory authorities haven't set a standard calculation method, so there is some wiggle room for accountants. For example, accounts can manipulate when accounts receivable and accounts payable are received, made, and recorded to boost free cash flow. One drawback to using the free cash flow method is that capital expenditures can vary dramatically from year to year and between different industries. That's why it's critical to measure FCF over multiple periods and against the backdrop of a company's industry. It's important to note that an exceedingly high FCF might be an indication that a company is not investing in its business properly, such as updating its plant and equipment. Conversely, negative FCF might not necessarily mean a company is in financial trouble, but rather, investing heavily in expanding its market share, which would likely lead to future growth. Value investors often look for companies with high or improving cash flows but with undervalued share prices. Rising cash flow is often seen as an indicator that future growth is likely. # How Do You Calculate Free Cash Flow? The simplest way to calculate free cash flow is to subtract capital expenditures from operating cash flow. Analysts may have to do additional or slightly altered calculations depending on the data at their disposal. We can calculate free cash flow by using: Operating cash flow Sales revenue Net operating profits Net Income # Summary Free cash flow is a metric that investors use to help analyze the financial health of a company. It looks at how much cash is left over after operating expenses and capital expenditures are accounted for. In general, the higher the free cash flow is, the healthier a company is, and in a better position to pay dividends, pay down debt, and contribute to growth. Free cash flow is one of many financial metrics that investors use to analyze the health of a company. Other metrics investors can use include return on investment (ROI), the quick ratio, the debt-to-equity ratio, and earnings per share (EPS). # Any Questions and Queries?