Understanding Free Cash Flow: Key to Financial Health

The best things in life are free, and that holds true for cash flow. Smart investors love companies that produce plenty of free cash flow (FCF). It signals a company's ability to pay down debt, pay dividends, buy back stock, and facilitate the growth of the business. However, while free cash flow is a great gauge of corporate health, it does have its limits and is not immune to accounting trickery.

What Is Free Cash Flow?

By establishing how much cash a company has after paying its bills for ongoing activities and growth, FCF is a measure that aims to cut through the arbitrariness and guesstimations involved in reported earnings. Regardless of whether a cash outlay is counted as an expense in the calculation of income or turned into an asset on the balance sheet, free cash flow tracks the money.

To calculate FCF, investors can use the cash flow statement and balance sheet. There, you will find the item cash flow from operations (also referred to as "operating cash"). From this number, subtract estimated capital expenditures required for current operations:

 $\begin{aligned} &\text{FCF}=\text{CFO}\ -\ \text{Capital Expenditures}\\ &\textbf{where:}\\ &\text{CFO}\ = \ \text{Cash flow from operations} \end{aligned}$​FCF=CFO − Capital Expenditureswhere:​

To do it another way, investors can use the income statement and balance sheet. Start with net income and add back charges for depreciation and amortization. Make an additional adjustment for changes in working capital, which is done by subtracting current liabilities from current assets. Then, subtract capital expenditures. The formula is as follows:

 $\begin{aligned} &\text{FCF}=\text{Net Income}+\text{DA}-\text{CC}-\text{Capital Expenditures}\\ &\textbf{where:}\\ &\text{DA}\ =\ \text{Depreciation and amortization}\\ &\text{CC}\ =\ \text{Changes in working capital} \end{aligned}$​FCF=Net Income+DA−CC−Capital Expenditureswhere:DA = Depreciation and amortization​

It might seem odd to add back depreciation/amortization since it accounts for capital spending. The reasoning behind the adjustment, however, is that free cash flow is meant to measure money being spent right now, not transactions that happened in the past. This makes FCF a useful instrument for identifying growing companies with high up-front costs, which may eat into earnings now but have the potential to pay off later.

Understanding the Implications of Free Cash Flow

Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF—due to revenue growth, efficiency improvements, cost reductions, share buybacks, dividend distributions, or debt elimination—can reward investors tomorrow. That is why many in the investment community cherish FCF as a measure of value. When a firm's share price is low and free cash flow is on the rise, the odds are good that earnings and share value will soon be on the up.

By contrast, shrinking FCF signals trouble ahead. In the absence of decent free cash flow, companies are unable to sustain earnings growth. An insufficient FCF for earnings growth can force a company to boost its debt levels. Even worse, a company without enough FCF may not have the liquidity to stay in business.

Recognizing Free Cash Flow Limitations and Pitfalls

Although it provides a wealth of valuable information that investors really appreciate, FCF is not infallible. Crafty companies still have leeway when it comes to accounting sleight of hand. Without a regulatory standard for determining FCF, investors often disagree on exactly which items should and should not be treated as capital expenditures.

Investors must, therefore, keep an eye on companies with high levels of FCF to see if these companies are under-reporting capital expenditures as well as research and development. Companies can also temporarily boost FCF by stretching out their payments, tightening payment collection policies, and depleting inventories. These activities diminish current liabilities and changes to working capital. But the impacts are likely to be temporary.

Unveiling Accounting Tricks: Hiding Receivables in Free Cash Flow

Another example of FCF foolery involves specious calculations of the current accounts receivable. When a company reports revenue, it records an account receivable, which represents cash that is yet to be received. The revenues then increase net income and cash from operations, but that increase is typically offset by an increase in current accounts receivable, which are then subtracted from cash from operations. When companies record their revenues as such, the net impact on cash from operations and free cash flow should be zero since no cash has been received.

What happens when a company decides to record the revenue, even though the cash will not be received within a year? The receivable for a delayed cash settlement is, therefore, "non-current" and can get buried in another category like "other investments." Revenue is still recorded and cash from operations increases, but no current account receivable is recorded to offset revenues. Thus, cash from operations and free cash flow enjoy a big but unjustified boost. Tricks like this one can be hard to catch.

Concluding Thoughts on Free Cash Flow

Alas, finding an all-purpose tool for testing company fundamentals still proves elusive. Like all performance metrics, FCF has its limits. On the other hand, provided that investors keep their guard up, free cash flow is a very good place to start hunting.