Master Class 16: What is Free Cash Flow? And how to calculate it?
Created on 10 Sep 2020
Wraps up in 5 Min
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Updated on 21 Sep 2022
When the lockdown was announced by the government, a lot of people immediately felt the pain of it. There might be a host of reasons behind it, but one of the most crucial reasons was a lack of liquidity. Most of them did not have sufficient funds to meet their day-to-day requirements. Similarly, companies are prone to liquidity crunch as well. Such an obstacle will affect the efficiency of the company.
As an investor, you will want to know your company's cash flow, particularly during times of crisis. One simple tool that will help you find a solution for this problem of yours is "free cash flow per share."
Now it's time we dive into the concept and find out how you can employ the same in your fundamental analysis. And at the end of the blog, you will be able to employ this method to your advantage.
Free Cash Flow
Free cash flow or FCF is the amount that is left after the company addresses its expenses, inventory, maintenance of capital assets, working capital requirements, and other operational expenses. It helps us understand the financial health and the trends of the company. It is one of the most important ratios one should consider before making an investment.
The free cash flow ratio can be used as a profitability yardstick as well. It is mostly expressed in terms of a per-share basis. It avoids all non-cash expenses and makes sure that the spending on equipment and capital assets are included.
Free Cash Flow = Cash from operations – Capital expenditure (or)
Free Cash Flow = Net income + Non-cash expenses – Increase in working capital – Capital expenditures
In order to find the free cash flow per share, you will have to divide the amount by the total number of shares outstanding.
For example: Say you run a Retail industry. Your net earnings of Rs. 1000. After paying off various expenses, you are now left with Rs. 100. This can be used for a variety of purposes and also reflects the financial health of the company. When you have Cash left out, you can address the operations effectively, especially when there are bad debts, delayed payment from the customers, or any unexpected disaster like Covid-19. A company which has a lower free cash flow will have to suffer to continue with its operations when hit by an issue.
You can find this ratio on the Ticker screener. Use the option "add your own ratio" to include the ratios of your choice.
Source: Hindustan Unilever on Ticker
What does Free Cash Flow mean?
A company can use its free cash flow for the following purposes,
- When there is enormous Cash left out, the company can use it to pay out dividends to the shareholders and other stakeholders of the firm.
- It can choose to reinvest the amount in order to stimulate the company to grow faster and better. Say you have a free cash flow of Rs.10. Now you can use this to produce additional units and therefore increase the capacity and earnings of the firm.
- It can also be employed in expansion or development activities such as investing in R and D, acquiring a new plant, hiring highly qualified professionals, etc.
- It can also buy back its stock. However, a company always goes in for such a decision when the market price of a particular share is less than its intrinsic value.
- Payback any outstanding debt or meet the credit obligations.
- Finally, it can make investments into shares, bonds, lend another company, buyout an ailing unit, invest startups, etc.
Hence, positive cash flow is always a promising sign. As an investor, you will be able to identify how much income the company you invested in was able to generate over and above the expense. It will also tell you how liquid an enterprise is. Further, as an investor, it is necessary that you acquire knowledge as to how your company is spending the amount.
Can companies have a zero free cash flow? Yes, that is possible as well. Sometimes the company may project good net earnings but might hold less or zero free cash flow. In that case, your decision should be based on how the company used the Cash. The best examples are those industries that have heavy competition like the Automobile sector. These industries will have to constantly invest in newer models and newer technologies in order to grow and be in business.
Have you read our previous Master Class: How to Read the Quarterly Results?
Negative Free Cash Flow
Sometimes you might come across companies having negative Free cash flow. It simply means the incapability of the company to keep up with its everyday business requirements. This poor financial health might be due to a list of causes. But it is up to the company to address the problem as soon as possible. Or otherwise, the company will be forced to acquire debt to run its business. This may result in the accumulation of the interest expenses or simply risk the dilution of equity shareholders. Either way, this might be dangerous for the business.
Therefore, positive cash flow not only attracts potential investors but also offers a company with enormous opportunities to grow and expand. Also, this figure is more reliable, owing to the difficulty that lies in its manipulation.
What is Cash flow per Share?
Earnings per Share or EPS tells an investor how much a company has generated for each of the shares. While the cash flow per Share tells the real profitability of the business from the various operations of the business. Unlike EPS, the ratio takes into account the one-time expenses and other irregular expenses. Hence, it offers an accurate statement when it comes to the financial standing of a company.
Cash flow per Share = (operating cash flow – preferred dividends) / no. of outstanding shares.
Most analysts prefer cash flow and free cash flow over earnings per share or EPS because they offer less or no scope for manipulation and appeal to be a clear reflector of the company's financial standing.
Apart from that, a few other differences between the two are as follows.
The Bottom Line
You don't have to be Einstein to make money in Dalal street. You need to have patience, an urge to constantly learn, and above all, the will to try what you learnt. Every investor who is now on the top of the ladder started from the beginning. Fallen multiple times and worked hard. So let that sweet start of yours begin right now. Endings might be difficult, but its fruits are the best.
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