What is Free Cash Flow?

Free cash flow is like being able to buy gas on Route 66...

There are road trips and then there are road trips. Imagine you decide to drive from Cali to Chicago and go out and buy a new sports car. As you are heading down Route 66, the fuel light comes on and you stop in at the nearest gas station. You open your wallet to pay and there is no cash. All your savings and your last paycheck have been used to purchase the car. You have no Free Cash Flow. The two options are that you pay using your credit card and go into debt (negative cash flow) or you camp out at the gas station until your next paycheck (positive cash flow) clears and you fill up the car.

Several formulas can be used to calculate free cash flow. Each method has a slightly different workaround and degree of complexity.

1.   Operating activities method

__Cash Flow from Operating Activities - Capital Expenditure = Free Cash Flow __

Using the cash flow statement, the operating activities method is simple and does not require additional calculation. It essentially strips out the expenses associated with the purchase, improvement, or maintenance of long-term assets, which includes the land, building, and equipment costs from available cash.

1.   Net profit method

__Net Profit + Interest – Changes in Working Capital – Net Capital Expenditure – Tax Shield __

When calculating the FCF from the income statement, it is important to add interest costs into net profit before subtracting changes in working capital (current assets – current liabilities), net capital expenditure (CAPEX – depreciation), and tax shield (marginal tax rate x interest).

1.   Net income method

__Net Income + Depreciation and Amortization – Changes in Working Capital – Capital Expenditure __

The net income method is used when the balance sheet and income statement are available. To ensure that we do not include any write-downs, such as X, Y, or Z, in the calculation, we need to account for depreciation and amortization, X and Y, respectively. Once again changes in working capital and CAPEX are subtracted from net income.

There are several terms you’ve got to nail down to understand free cash flow. As highlighted in the above example, negative free cash flow or ‘Burn Rate’ as it is known, is when a company has higher costs than available cash. A ‘Surplus’, on the other hand, means the company is in a strong cash position and can pay dividends, reduce debt and buyback, or implement stock buyback programs.

Free cash flow can be levered or unlevered. Levered free cash flow takes a company’s interest expense into account. Unlevered free cash flow, on the other hand, assumes the company has no interest expense (aka the company has no debt). To calculate unlevered free cash flows, analysts need to remove the interest expense and estimate what taxes would be excluding the interest expense.

There is no right or wrong answer when it comes to deciding whether to use free cash flow or earnings before interest, tax, and depreciation (EBITDA). Each has its place in the accounting world, and each offers a slightly different reporting dynamic.

Think of FCF as the extractable cash from a business. There are no write-downs on capital expenditure, and everything is accounted for at the time of purchase. This tends to give an immediate picture of the financial health of the company.

Earnings, on the other hand, allow a company to write-down its fixed asset costs over a period, so it does not have an immediate, full effect on earnings. Say, for example, a company buys a new warehouse for $700,000 – the head of finance decides to write off the cost of the property over 7 years. The cost in year one is now $100,000, not $700,000.

A quick way to help assess the attractiveness of a company from a solvency point of view is through the use of the free cash flow yield. Calculated by dividing the free cash flow per share by the market price of the share, a lower ratio indicates that investors may be paying too much for each unit of free cash flow. The yield once again is subject to interpretation and is dependant on the accuracy of CAPEX and free cash flow.

From a reporting perspective, free cash flow can be bumpy at times and is open to interpretation. If a company has recently invested in new equipment to support growth and ultimately has pushed the FCF into the red - this would come up as a warning signal for an investor. This may or may not be cause for concern to prudent business management. To combat this problem, analysts tend to look at the overall FCF trend, and discount one-off anomalies.

Simulating future growth patterns can be almost impossible when using free cash flow. Forecasting generally looks at the current position of the company, and is subject to today’s market assumptions. The conditions today will almost certainly not be the same in 6 months or a year.

Another limitation of capital expenditure is its lack of consistency. CAPEX, in its pure form, should be divided into asset maintenance and growth. The generally accepted accounting principles (GAAP) do not currently require both to be separated, which could lead to erroneous and misleading free cash flow figures.

The final drawback of free cash flow is the ability to manipulate based on reporting needs. This, however, can occur with any financial metric and it is really up to the internal policies and accounting standards of the company. In the case of Enron, the ability to forecast the insolvency of the company was near impossible for investors due to creative account and the manipulation of their financial statements.

Free cash flow is increasingly being applied in the world of personal finance as well. Home loans and car loans are subject to ‘serviceability’ requirements, with banks and lenders using cash flow, earnings,and liabilities to understand the borrower’s position better. Free cash flow provides a current financial snapshot of available funds after assets/investments. These could include cars, investment properties, computer equipment, and more

It's difficult to define ''good'' free cash flow, as many factors should be considered when evaluating the FCF of a company. Companies operate differently, and some sectors are more capital intensive than others. The oil and gas industry, for example, would have higher CAPEX costs than the information technology sector. Profitability and growth are still consistent, even though many of these companies would have short term ‘burn.’ This does not mean they are not profitable in the long run.

On the flip side, organizations who are sitting on a lot of parked cash and saving for a rainy day can be viewed warily. Dividends, share buybacks, or reinvestment have become almost par for the course.

‘Good’ free cash flow can also be skewed by credit. If a company has outstanding accounts receivable, then its overall cash flow will fall. CAPEX, in most cases, will not adjust as it is a fixed cost, and this will adversely affect the FCF.

A fundamental based methodology, value investing in its most simple form aims to identify opportunities that are trading at a discount to the perceived book or intrinsic value. It can be described as finding a limited-edition Michael Jordan rookie basketball card at a garage sale.

Renowned investor Warren Buffett has successfully used value investing to build his Berkshire Hathaway business into one of the largest companies in the world with a market capitalization of $515B as of September 17, 2019. (Source: Yahoo Finance,2019). Free cash flow is a key component of value investing, and can be used to create valuation models to identify potentially undervalued businesses. FCF seeks to provide the investor with the ability to assess distributions (what shareholders may ultimately receive) and better illuminate enterprise value.