Free Cash Flow

To find the ultimate measure of profitability the above cash flow analysis must be taken a step further to determine what is called “free cash flow”. Companies can generate enormous amounts of cash flow from operations but still not be truly profitable if they are required to continuously reinvest that cash into their infrastructure to maintain their business operations. As cash flow analysts, we want to determine how much cash is left over after all the costs to maintain the business are removed. This value is free cash flow and represents money a company can use for shareholder benefit whether it be in the form of a dividend, paying down debt, repurchasing of shares, investment, or acquisitions. It can be thought of as cash that is “free” to do whatever with and it is the purest form of profit a company generates.

To determine free cash flow the costs of maintaining the business from the net cash flow from operations need to be subtracted. The cost of maintaining most businesses primarily consists of capital expenditures. Examples of capital expenditures include buildings, vehicles, IT systems, and equipment. Fortunately, this information is in the Statement of Cash Flows but requires some digging to find it. Remember the section on Cash from Investing Activities from above? Well, there is a subsection called PPE (Property, Plant, & Equipment) or sometimes called Capital Expenditures, that provides how much money the company spent on maintaining its infrastructure. Subtract this value from the Net Cash from Operations section and you have free cash flow.

It is important to note that there is no standard definition of free cash flow or the way it is calculated. You may see slightly different values among analysts because some also subtract items that, in their opinion, are not operational income. An example is the benefit from stock options which is sometimes included in the Operating Activities section of the Cash Flow statement. Some companies make this information available in the quarterly report but others do not. These miscellaneous items are usually dwarfed in magnitude by the capital expenditures so their affect on the final free cash flow number is not that significant. Free Cash Flow To Equity is another common value ratio that measures how much cash can be paid to the equity shareholders after all expenses and debts are paid.

It is important to make a long term analysis of free cash flows and not harp on any one quarter’s results. If a company has a large negative free cash flow value in a quarter it does not necessarily mean it is unhealthy. Since free cash flow is immune to the amortization features in earnings, it will be significantly impacted by a large capital expense such as the construction of a new plant. It is therefore important to analyze a company’s free cash flow over many quarters.