If you want to know how much cash a company has to invest in its growth, distribute dividends, or reduce its debt, you need to understand the term Free Cash Flow (FCF). It's crucial for determining a company's financial position and is probably the most relevant metric for any stock investor to analyze. In fact, the most commonly used valuation methods rely on this figure as the main element. For this reason, if you're looking to strengthen your knowledge of investing in the U.S. stock market, stick around to easily learn what Free Cash Flow is.

What is Free Cash Flow?

Free Cash Flow (FCF) is the amount of money left after a company pays its operating expenses and capital expenditures. In other words, Free Cash Flow reflects the cash generated by a business after making long-term investments in assets.

How to calculate Free Cash Flow?

Usually, there are two different methods to calculate Free Cash Flow because not all companies have the same financial statements. Regardless of the method used, the result should be the same for each company.

The general formula to calculate FCF is operating cash flow minus CapEx (or Capital Expenditures). This method is the most popular because it uses two data points that are easy to find in the financial statements.

Free Cash Flow (FCF) = Operating Cash Flow – CapEx

To find operating cash flow, you need to access the company’s Cash Flow Statement. Similarly, to find CapEx, you just need to locate it on the company's Balance Sheet.

It can also be calculated in more detail using net income:

Free Cash Flow (FCF) = Net Income + Depreciation - Change in Working Capital - CapEx

Let's look at an example. Suppose Juan's income statement shows a net income of $10,000 after taxes last year. To calculate operating cash flow, we need to add depreciation and subtract the change in working capital. Additionally, we have the following data:

• Depreciation: $1,000
• Current assets: $1,000
• Current liabilities: $800
• CapEx: $5,000

With this information, we can find the required figures:

Operating Cash Flow = Net Income + Depreciation - Change in Working Capital

Operating Cash Flow = 10,000 + 1,000 - (1000 - 200) = $10,200

Free Cash Flow = Operating Cash Flow - CapEx

Free Cash Flow = 10,200 - 5,000 = $ 5,200

So, Juan's business will have $5,200 in Free Cash Flow (FCF).

Why is Free Cash Flow important and what is it used for?

Simply put, FCF is the money available to a company after a year of operations. Calculating and analyzing FCF is crucial for managing a company’s cash. It is one of the most effective performance metrics because it shows how efficiently a company generates cash and is harder to manipulate than net income. For this reason, it’s the main component that investors project to determine the fundamental value of a business.

Positive cash flow means the company has significant money available to reinvest or distribute to shareholders in the future. Typically, companies with a long track record in the market have positive FCF, which is useful for several actions:

• Acquiring other businesses
• Repurchasing shares to foster company growth
• Reducing debt
• Paying dividends to investors

How do earnings and Free Cash Flow differ?

Net income or earnings and free cash flow are related but are not the same measure. Earnings represent a company’s profit on the income statement, while free cash flow is measured through the Cash Flow Statement and reflects the cash available to spend on growth or distribute to shareholders.

What happens when Free Cash Flow is negative?

When FCF is negative, the company lacks the cash to continue growing. A company with decreasing or consistently low FCF may need restructuring because little money is left at the end of each period.

However, negative cash flow isn’t always bad. Many business models have negative cash flows for long periods, backed by more investor support to grow at an exponential rate to expand their market share and then monetize that user base.

It’s also important to note that excessively high FCF could indicate that a company isn’t investing adequately in its business, such as updating its plant and equipment. Ultimately, the key is to look beyond the numbers, understand the stage and sector the company is in, and interpret FCF accordingly.

Conclusion

In summary, free cash flow measures how much cash a company has left after covering the costs associated with staying in business. The easiest way to calculate it is by subtracting CapEx from operating cash flow, and this number is essential when valuing a business. With this concept, you’ll gain a deeper understanding of the investment world, especially in the U.S. stock market. If you're interested in investing easily from Latin America, Hapi is your perfect partner. You can invest in stocks without commissions and cryptocurrencies instantly. Just click here to start your journey as an investor.