Free cash flow (FCF) is one of the best indicators of a company’s health, and unlike other indicators, free cash flow is quite easy to understand. You can think of free cash flow as the deposit that you take to your bank after paying all your monthly bills. If the deposit keeps on increasing, then you know you are on the right path regarding your financial status. But if the deposit keeps on shrinking, then you should be aware that there is something terribly wrong somewhere with your finances. Free cash flow operates in just the same manner. This article gets into the details of what is free cash flow and its importance to a business.
Understanding What Is Free Cash Flow
Free cash flow (FCF) refers to the amount of money that a company has after sorting out the cost of its operations and capital expenditure. It is essentially what the company generates by conducting its day-to-day business operations. The expenditures include things like upgrading the buildings and buying of new machinery. FCF is usually a net number since it is the figure arrived at after cash flow and expenditures. Free cash flow (FCF) comes in two distinct forms:
- Levered free cash flow (LFCF)
- Unlevered free cash flow (UFCF)
The value of levered cash flow is calculated by deducting capital expenditures from cash flow operations and then adding interest income and expense. While to get the value of unlevered cash flow you need to deduct capital expenditures from cash flow operations.
What are the uses of levered and unlevered free cash flow for companies?
Free cash flow is useful in creating the value of a company. Without cash, a company can undertake innovations, settle their debts or even perform takeovers. Levered free cash flow (LFCF) is particularly useful in LBO modeling since it reveals the amount of money the company will have to pay for the debts used to finance buyouts. Among the two forms of free cash flow, unlevered is the one that is widely used by companies and corporations. Free cash flow is quite essential since it shows the amount of money that a firm can generate after deducting asset expenditures.
Uses of Free Cash Flow
What is free cash and how does it apply in the business world? Free cash flow is used in a variety of ways by businesses and corporations. One of the uses is that it can be used for paying off dividends. Dividends refer to the money paid to the shareholders of a company or business at the end of a stipulated period. Shareholders are usually paid from the net earnings of the business or corporation.
Free cash flow can also be used for buying back stock, saving for future acquisitions, lowering debt and diluting stock. Without FCF the organization will find it challenging to expand its operations since the business cannot grow without issuing new debt or diluting the stock. FCF is a good indicator that a company can maintain and increase its operations. Except in the case of startup businesses which may show negative cash flow in the first few years of operation.
Bonus read – What is Equity?
Advantages and Disadvantages of Free Cash Flow
Free cash flow shows that it is an excellent tool for use by short term investors. However, it doesn’t offer much value to long-term investors. It is accurate, provides actual values and eliminates guess work on the one hand. On the other hand, free cash flow has the disadvantage of undervaluing companies that have an enormous potential for growth. For instance, in 1997, an estimated free cash flow showed that Microsoft would dominate the market in the future, compared to Apple. However, it turned out that Apple would grow and dominate the tech market, while Microsoft would be experiencing a sluggish growth.
Free cash flow has several merits for your organization. To answer the question of what is free cash flow and how it can benefit a business, let’s have a look at its advantages and disadvantages.
Advantages of Free Cash Flow
1. FCF offers a close and intrinsic stock value
Stock taking is an activity that most businesses do every day. However, most of the methods used in comparing stock are relative, and they only give estimates. Most of the businesses use these methods because they are easy to apply, but they don’t give the accurate information. Remember that one wrong calculation can make a bad stock appear to be good. Therefore, free cash flow provides investors with a closer and intrinsic stock value for better decision making.
2. It can be used to determine the future of a company
So, what is free cash flow and how can it be used to determine the future of a company? Free cash flow gives investors an opportunity to peep into the future of a company. All they need to do is to calculate backward from the current price of the stock and cash flow and predict how fast their company will be growing in the future. It helps the investors determine the real value of their company, and whether or not the value of their company is over-valued or undervalued by the market.
3. It reduces uncertainty
So, what is free cash flow and how does it reduce uncertainty? No investor is sure about how the market will be tomorrow. Free cash flow does not eliminate uncertainty. What FCF does is to help investors separate stock that makes sense from the one that is likely to result in losses. By removing some of the significant risks, the investors are left to work on things that will help to grow their wealth.
Disadvantages of Free Cash Flow
1. It works best when there is visibility
Unlike other measurements, free cash flow works best in an environment where there is complete transparency. If there are issues concerning company sales practices, cost trends and other items that affect cash flow, then FCF will not give accurate information.
2. It does not offer much value to a long term investor
Free cash flow works best for individuals who are looking into short term investment of say 5 to 10 years. It, however, offers little value to a person seeking to invest their money for maybe 20 or more years. FCF would give inaccurate figures to a long term investor. This is due to the fact that there are so many variables in between the years.
3. It only works based on projections made by the investor
Free cash flow is not devoid of assumptions. The investor needs to make some assumptions at some point about the future of the company. The accuracy of the investor’s assumptions will determine whether he will hit the nail on the head, or the hammer will fall on his thumb. An assumption that gives a difference of 1% could change the financial outlook for some companies by millions of dollars.
As an investor, you should always begin your investment journey in mind. Knowing what is free cash flow, you can assess the future of your business and determine whether your efforts will pay off or not. You can make accurate forecasts on your short term investment with a free cash flow. Free cash flow shows that a company is in the right trend and it can maintain a smooth running of its operations.