Imagine you own a business. It brings in a million dollars of revenue every year. That's great, right?
Not necessarily! What are your expenses? What if it costs you two million dollars to run the business every year? What if that million dollars exists only on paper, and you haven't managed to get everyone who owes you money to pay you yet? What if you owe half of that money in taxes?
Revenue in and of itself isn't a great way to see if your company is succeeding or failing. Revenue on paper doesn't tell you whether a business is a good investment. There are better (more accurate, more understandable, less easily manipulated) ways to measure the financial health of a business.
What is Free Cash Flow?
Free cash flow is the amount of money a company has left over after it pays its bills. It's what's left over of the money the business has actually collected when it's paid out all of its expenses. To calculate free cash flow, add up everything that comes in. Subtract everything that goes out. Free cash is what's left over.
What does cash flow mean? You can do things with it. This is capital available to reinvest in the business (buying a new factory or developing a new product line), acquiring other companies, pay dividends to share holders, buy back shares, and more. This is the money you can use to make more money next year and the next and so on.
Why is Free Cash Flow Important?
A business exists to make money. If you're investing in a North American maple syrup conglomerate, you want to know if the money you spend buying stock will be worth it. Is it a good business? Is it well managed? Is it making money every year? Can it reinvest profits in the business? If there are no good business opportunities at a good value right now, can it return that profit to the shareholders?
Is buying a share of the stock better for you in the long run than putting that money in an envelope and hiding it under your mattress? This is the one question to answer for every long term investment: what kind of money can the business generate every year? That's how you compare investments: given the risk and the rate of return, which fits your investing profile better?
FCF is also the foundation of certain types of value investing analysis, such as discounted cash flow; that's slightly more complicated, but it can help you determine the right price to pay for a share of stock.
Free Cash Flow Versus Net Income
Accounting is a tricky subject. It's easy to hide important details in financial reports. Suppose your company builds a new factory in Canada to make maple syrup. It may cost $1,000,000 to build, but you can amortize that capital expense over five years and make it look like you only spent $200,000 every year on that factory. That's legal and helps with taxes, but in fact, you paid a cool million that first year. That money's gone. Your free cash is a million dollars lower than if you hadn't spent it.
That doesn't make accounting bad; saving money on taxes is often a very good thing. This does mean you should look suspiciously at the Net Income numbers in financial reports. Do they really reflect actual cash and cash equivalent holdings?
Free cash flow is important to a business as an accurate picture of how much money the company really has every year because it doesn't hide details in amortization and depreciation. (That sentence is really boring, but it's also really important.)
What is Negative Free Cash Flow?
Negative free cash flow is when your business has more bills than revenue. A young company may be in this situation on purpose: someone's pumping money into the company in an attempt to help it grow larger. For example, a software company may need a couple of million dollars to hire programmers and devops people and buy servers so that it can sell its services. This will take a couple of years. Free cash flow will be negative until that business takes off.
Similarly a company may decide to take on some debt to build a factory, knowing that it can survive for a little while without having a positive free cash flow. The expanded capacity will let it grow larger and make more money in the future.
Neither of these are bad situations, but they can make free cash flow negative in the short term. These may still be good investments; you have to look deeply into the companies to understand the strategy. Sometimes an investment costs a little more in the short term to make a lot more in the long term
Free Cash Flow Analysis for Value Investors
A company in financial trouble will have more trouble hiding a free cash flow problem than net income problems. Because net income is easy to manipulate, a company such as Enron can mislead unwary investors. Yet looking only at free cash flow and seeing that it's increasing year after year doesn't answer the most important question to investors:
What does a company do with its revenue?
A reputable business strives to do the best thing available for its shareholders. If that means holding on to money as a buffer against lean times, so be it. If that means trying to expand by buying smaller companies to increase efficiency or gain customers or inventory, so be it. If there's no good use for the money now or in the near future and that cash is better in the hands of shareholders, then the company ought to pay it out in a dividend or perform stock buybacks.
Of course, a company that's spending more money on stock buybacks or dividend payouts than it has available in free cash is in severe financial trouble and is trying to make things look a lot better than they are—so be wary of that, too.
What is Good Cash Flow for Investors?
Free cash flow is the measurement of a company's ability to generate excess cash for its investors. It's not the only measurement of a company's financial health. It's only one piece of value investing, but it's very, very important. A healthy company reliably and repeatedly produces free cash from its operations, then uses this money to improve the value of the business and, thus, return value to its shareholders.
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