Investing Fundamentals: Free Cash Flow [Part 1]

What is free cash flow and why is it important?

What is Free Cash Flow?

Free cash flow (FCF) is the money a company generates after taking into consideration cash outflows that are needed to support its operations and maintain its capital assets. In other words, free cash flow is the money left over after a company pays for its operating expenses and capital expenditures. Capital expenditure is money spent to acquire tangible assets such as buildings or machinery or intangible assets such as software or patents.

Why is Free Cash Flow Important?

If I could only evaluate a business based on one metric it would have to be free cash flow. The expression cash is king is just as applicable when it comes to investing as it is when applied to other real-world scenarios. The reason free cash flow is such an important metric is that it is not subject to artificial manipulation that line items like net profit may be subject to. Profit on the income statement can be misleading due to accounting entries such as unrealised fair value gains/losses or impairments on assets. For example, imagine a hypothetical Company X which generated operating losses of R1 million for the year but realised a R2 million gain on an unlisted investment that is valued internally by management. In this instance, you may be misled when looking at the net income which shows an impressive R1 million net profit, but has the business performed well and can we rely on this subjective R2m million fair value gain?

Had you decided to instead look at the free cash flow of the business you would see that cash from operations was negative and as result so was free cash flow. Based on this negative free cash flow you may have second guesses about investing in this company.

Free cash flow is also important to investors because it shows how effective the company is at turning revenue and profits into cash for shareholders. So, while Company A might have R10 million in net profit it may only be able to convert 10% of its profits on average into cash resulting in FCF of only R1 million for shareholders. Thus, assuming Company B was selling for the same price per share and had net profits of only R5 million but was able to convert 50% of this into cash, youd be a much happier shareholder of Company B which had FCF of R2.5 million.

How do you calculate Free Cash Flow?

Free cash flow is calculated by taking cash from operations or operating cash flow directly from the cash flow statement and subtracting capital expenditure. Capital expenditure may not always appear as a distinct line on the cash flow statement. In instances where capital expenditure is not shown directly on the cash flow statement, it can be calculated from the cash from investing activities section of the cash flow statement. From the cash flow statement, you can add cash spent on investments into fixed or intangible assets to determine capital expenditure. This can include the purchase of PPE, land and buildings or software for example.

What can a business use Free Cash Flow for?

Now that we know what free cash flow is and how to calculate it we need also to understand what a company can do with its free cash flow / excess cash. The management of a company can allocate FCF in one of the following ways:

Dividends

Paying a cash dividend is one of the first and most obvious choices for allocating the free cash flow. Investors love dividends, and they are an important part of the investing process for most investors. Paying a growing dividend is also a fantastic way for a company to attract investors on a growing basis.

 However, depending on where a company is in its life cycle it may not always be appropriate to pay dividends. Typically, younger companies arent in a position to pay dividends and use their funds to reinvest for more growth or pay down debt. As the company matures, it may choose to start to pay a dividend to attract more investors or give back to those who have stayed loyal to them over time.

Share buybacks

Share buybacks function as a means of returning value to shareholders in the form of more value for the shares they currently own. Once a buyback is instituted, the shareholder sees their per-share value increase with the reduction of shares available for sale. 

Imagine Company A has an issued share capital of 100 shares and you currently own 10 shares (i.e., 10%). If Company A decided to buy back 10 outstanding shares the issued share capital would drop from 100 to 90. Instead of owning 10% of the company, you would now own 11.11% (10/90) and thus the value of your investment has increased.

Paying off debt

Paying off debt has several beneficial consequences for the company. First, as the debt is paid down over time, the interest expense will decrease, which will open up more profit for the company to use for any capital needs.

Another benefit is the ability to borrow more money if the company feels that it is a route they want to go. As the debt is paid down, it shows banks and other lenders that the company has control over its capital and will be far more likely to loan to the company again.

Paying off debt is a particularly wise move to make in a rising interest rate environment. When the government hikes interest rates your cost of debt and interest expense goes up unless your debt is at a fixed rate.

Reinvesting back into the company

Using the free cash flow as a means of growth for the company is probably the greatest use if the company is still in the growth phase of its life cycle.

 Think of companies like Facebook, Amazon, Google, Apple, Netflix, Visa, and many others. All of these companies have done a fantastic job of creating free cash flow and reinvesting back into their companies to achieve a higher rate of return for shareholders than had the cash been used for other purposes. If a happy has a high return on invested capital (ROIC), reinvesting back into the business is likely the most beneficial option for shareholders.

Acquisitions

Buying other companies is another example of how a business can use free cash flow to grow. Companies acquire other companies for various reasons. They may seek economies of scale, diversification, greater market share, increased synergy, cost reductions, or new niche offerings.