Ratios: Free Cash Flow: Videos & Practice Problems

Free cash flow (FCF) measures the cash generated from a company's operating activities after accounting for capital expenditures and dividends. It is crucial because it indicates the company's ability to generate sustainable cash flow, which can be used for expansion, paying dividends, or reducing debt. Positive FCF suggests strong financial health, while negative FCF may indicate low operating cash flows or significant investments in fixed assets. Understanding FCF helps investors and analysts assess a company's financial stability and growth potential.

Free cash flow (FCF) is calculated using the formula:

$\mathrm{FCF}=\mathrm{Cash} \mathrm{from} \mathrm{Operating} \mathrm{Activities} - \mathrm{Capital} \mathrm{Expenditures} - \mathrm{Dividends}$

First, find the cash from operating activities from the statement of cash flows. Then, subtract capital expenditures, which are investments in fixed assets. Finally, subtract any dividends paid to shareholders. The result is the free cash flow, representing the cash available for expansion, debt repayment, or other purposes.

A negative free cash flow (FCF) can indicate two main scenarios. First, it may suggest that the company's operating cash flows are insufficient to cover capital expenditures and dividends, signaling potential financial distress. Second, it could mean the company is heavily investing in fixed assets to expand its operations, which might lead to higher cash flows in the future. Therefore, while negative FCF can be a red flag, it is essential to analyze the underlying reasons to understand its implications fully.

Free cash flow (FCF) and net income are different financial metrics. FCF focuses on the actual cash generated from operating activities after capital expenditures and dividends, providing a clear picture of cash availability. In contrast, net income is an accounting measure that includes non-cash items like depreciation and amortization, reflecting the company's profitability. While net income is important for understanding profitability, FCF is crucial for assessing a company's liquidity and ability to fund growth or return value to shareholders.

Investors focus on free cash flow (FCF) because it provides a clear indication of a company's ability to generate cash from its core operations. Unlike net income, which can be influenced by accounting practices, FCF reflects the actual cash available for expansion, paying dividends, or reducing debt. Positive FCF suggests financial stability and growth potential, making the company an attractive investment. Additionally, FCF helps investors assess the sustainability of a company's dividend payments and its capacity to invest in future growth opportunities.