Free Cash Flow (FCF)

By JOHN A. JAGERSON

What is Free Cash Flow (FCF)?

Free cash flow (FCF) represents the cash a company generates after accounting for cash
outflows to support operations and maintain its capital assets. Unlike earnings or net
income, free cash flow is a measure of profitability that excludes the non-cash expenses of
the income statement and includes spending on equipment and assets as well as changes
in working capital from the balance sheet.

Interest payments are excluded from the generally accepted definition of free cash flow.
Investment bankers and analysts who need to evaluate a company’s expected performance
with different capital structures will use variations of free cash flow like free cash flow for
the firm and free cash flow to equity, which are adjusted for interest payments and
borrowings.

Similar to sales and earnings, free cash flow is often evaluated on a per share basis to
evaluate the effect of dilution.

KEY TAKEAWAYS

 Free cash flow (FCF) represents the cash available for the company to repay
creditors or pay dividends and interest to investors.
 FCF reconciles net income by adjusting for non-cash expenses, changes in working
capital, and capital expenditures (CAPEX).
 However, as a supplemental tool for analysis, FCF can reveal problems in the
fundamentals before they arise on the income statement.
Understanding Free Cash Flow (FCF)
Free cash flow (FCF) is the cash flow available for the company to repay creditors or pay
dividends and interest to investors. Some investors prefer FCF or FCF per share over
earnings or earnings per share as a measure of profitability because it removes non-cash
items from the income statement. However, because FCF accounts for investments
in property, plant, and equipment, it can be lumpy and uneven over time.

Benefits of Free Cash Flow (FCF)

Because FCF accounts for changes in working capital, it can provide important insights into
the value of a company and the health of its fundamental trends. For example, a decrease
in accounts payable (outflow) could mean that vendors are requiring faster payment. A
decrease in accounts receivable (inflow) could mean the company is collecting cash from
its customers quicker. An increase in inventory (outflow) could indicate a building
stockpile of unsold products. Including working capital in a measure of profitability
provides an insight that is missing from the income statement.
For example, assume that a company had made $50,000,000 per year in net income each
year for the last decade. On the surface, that seems stable but what if FCF has been
dropping over the last two years as inventories were rising (outflow), customers started to
delay payments (outflow) and vendors began demanding faster payments (outflow) from
the firm? In this situation, FCF would reveal a serious financial weakness that wouldn’t
have been apparent from an examination of the income statement alone.

FCF is also helpful as the starting place for potential shareholders or lenders to evaluate
how likely the company will be able to pay their expected dividends or interest. If the
company’s debt payments are deducted from FCF (Free Cash Flow to the Firm), a lender
would have a better idea of the quality of cash flows available for additional borrowings.
Similarly, shareholders can use FCF minus interest payments to think about the expected
stability of future dividend payments.

Limitations of Free Cash Flow (FCF)

Imagine a company has earnings before depreciation, amortization, interest, and taxes
(EBITDA) of $1,000,000 in a given year. Also, assume that this company has had no
changes in working capital (current assets – current liabilities) but they bought new
equipment worth $800,000 at the end of the year. The expense of the new equipment will
be spread out over time via depreciation on the income statement, which evens out the
impact on earnings.

However, because FCF accounts for the cash spent on new equipment in the current year,
the company will report $200,000 FCF ($1,000,000 EBITDA - $800,000 Equipment) on
$1,000,000 of EBITDA that year. If we assume that everything else remains the same and
there are no further equipment purchases, EBITDA and FCF will be equal again the next
year. In this situation, an investor will have to determine why FCF dipped so quickly one
year only to return to previous levels, and if that change is likely to continue.

Additionally, understanding the depreciation method being used will garner further
insights. For example, net income and FCF will differ based on the amount of depreciation
taken per year of the asset's useful life. If the asset is being depreciated using the book
depreciation method, over a useful life of 10 years, then net income will be lower than FCF
by $80,000 ($800,000 / 10 years) for each year until the asset is fully depreciated.
Alternatively, if the asset is being depreciated using the tax depreciation method, the asset
will be fully depreciated in the year it was purchased, resulting in net income equaling FCF
in subsequent years.

Calculating Free Cash Flow (FCF)

FCF can be calculated by starting with Cash Flows from Operating Activities on
the Statement of Cash Flows because this number will have already adjusted earnings for
non-cash expenses and changes in working capital.
The income statement and balance sheet can also be used to calculate FCF.

Other factors from the income statement, balance sheet and statement of cash flows can be
used to arrive at the same calculation. For example, if EBIT was not given, an investor
could arrive at the correct calculation in the following way.

While FCF is a useful tool, it is not subject to the same financial disclosure requirements as
other line items in the financial statements. This is unfortunate because if you adjust for the
fact that capital expenditures (CAPEX) can make the metric a little “lumpy,” FCF is a good
double-check on a company’s reported profitability. Although the effort is worth it, not all
investors have the background knowledge or are willing to dedicate the time to calculate
the number manually.

How To Define “Good” Free Cash Flow (FCF)

Fortunately, most financial websites will provide a summary of FCF or a graph of FCF’s
trend for most public companies. However, the real challenge remains: what constitutes
good Free Cash Flow? Many companies with very positive Free Cash Flow will have
miserable stock trends, and the opposite can also be true.

Using the trend of FCF can help you simplify your analysis.

A concept we can borrow from technical analysts is to focus on the trend over time of
fundamental performance rather than the absolute values of FCF, earnings, or revenue.
Essentially, if stock prices are a function of the underlying fundamentals, then a positive
FCF trend should be correlated with positive stock price trends on average.

A common approach is to use the stability of FCF trends as a measure of risk. If the trend
of FCF is stable over the last four to five years, then bullish trends in the stock are less
likely to be disrupted in the future. However, falling FCF trends, especially FCF trends that
are very different compared to earnings and sales trends, indicate a higher likelihood of
negative price performance in the future.

This approach ignores the absolute value of FCF to focus on the slope of FCF and its
relationship to price performance.

Example of Free Cash Flow (FCF)

Consider the following example:

What would you conclude about a stock’s likely price trend with diverging fundamental
performance?

Based on these trends, an investor would be on alert that something may not be going well
with the company, but that the issues haven’t made it to the so-called “headline
numbers” – revenue and earnings per share (EPS). What could cause these issues?

Investing in Growth
A company could have diverging trends like these because management is investing in
property, plant, and equipment to grow the business. In the previous example, an investor
could detect that this is the case by looking to see if CAPEX was growing in 2016-2018. If
FCF + CAPEX were still upwardly trending, this scenario could be a good thing for the
stock’s value.

Stockpiling Inventory
Between 2015 and 2016, Deckers Outdoor Corp (DECK), famous for their UGG boots,
grew sales by a little more than 3%.1 However, inventory grew by more than 26%, which
caused FCF to fall that year even though revenue was rising.2 Using this information, an
investor may have wanted to investigate whether DECK would be able to resolve their
inventory issues or if the UGG boot was simply falling out of fashion, before making an
investment with the potential for extra risk.

Credit Problems
A change in working capital can be caused by inventory fluctuations or by a shift in
accounts payable and receivable. If a company’s sales are struggling, so they extend more
generous payment terms to their clients, accounts receivable will rise, which may account
for a negative adjustment to FCF. Alternatively, perhaps a company’s suppliers are not
willing to extend credit as generously and now require faster payment. That will reduce
accounts payable, which is also a negative adjustment to FCF.

From 2009 through 2015 many solar companies were dealing with this exact kind of credit
problem. Sales and income could be inflated by offering more generous terms to clients.
However, because this issue was widely known in the industry, suppliers were less willing
to extend terms and wanted to be paid by solar companies faster. In this situation, the
divergence between the fundamental trends was apparent in FCF analysis but not
immediately obvious by just examining the income statement alone.