FREE CASH FLOW
FREE CASH FLOW
You can't fake it
Maybe you've heard the term Free Cash Fow. What does it mean and why is it important? Let's take a look at free cash flow and how it can help you evaluate the performance of a business. You might be interested in a recent episode with Chris Batchelor from Stockopedia where we have an extended discussion about this topic.
Free cash flow is the amount of money that a business generates after paying for its operating expenses and investing in its growth. It is the cash that is left over for the owners or shareholders of the business to use as they wish. They can use it to pay off debt, save for future projects, or distribute as dividends.
To understand free cash flow, we need to start with operating cash flow. Operating cash flow is the money that a business makes from its core activities, such as selling products or services. For example, if you are a cafe, you have revenues when customers pay for their food and drinks, and expenses when you pay your staff, rent, and suppliers. The difference between your revenues and expenses is your operating cash flow.
Be careful though, operating cash flow does not tell the whole story. A business also needs to invest in its growth, such as buying new equipment, expanding to new locations, or developing new products. These investments are called capital expenditures, and they reduce the amount of cash that is available for the owners or shareholders. Therefore, to calculate free cash flow, we need to subtract capital expenditures from operating cash flow.
Free cash flow = Operating cash flow - Capital expenditures
Free cash flow is often seen as a better indicator of a business's health than other metrics, such as net income or earnings per share. This is because free cash flow reflects the actual cash that a business generates, rather than accounting estimates or assumptions. As the saying goes, "profit is opinion, cash is fact".
For a beginner investor, free cash flow can reveal how well a business is managing its operations and investments. A positive free cash flow means that a business is generating more cash than it needs to run and grow, which is a sign of efficiency and profitability. A negative free cash flow means that a business is spending more cash than it earns, which could indicate problems or opportunities.
Of course, free cash flow is not the only factor to consider when evaluating a business. It is also important to look at the quality and sustainability of the cash flows, as well as the growth potential and competitive advantage of the business. Some businesses may have low or negative free cash flows because they are investing heavily in their future growth, which could pay off in the long run. Others may have high or positive free cash flows because they are mature or declining businesses that have limited growth opportunities.
You should not rely solely on free cash flow to judge a business's performance. You should also look at other factors that affect its value and prospects. Free cash flow is a useful tool to understand how a business generates and uses its cash, but it is not the only one.
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