Free cash flow

Definition

Free cash flow (FCF) is the cash generated by a company's operations after accounting for capital expenditures necessary to maintain or expand its asset base. This metric is crucial because it reflects the actual cash available for distribution to investors, such as shareholders and creditors, beyond what is needed for the business's operational needs. Understanding FCF helps in evaluating a company’s financial health and potential for growth, connecting directly to the assessment of dividend policies and valuation through various models.

5 Must Know Facts For Your Next Test

1. Free cash flow is calculated using the formula: FCF = Operating Cash Flow - Capital Expenditures.
2. Positive free cash flow indicates that a company has sufficient funds to invest in growth opportunities, pay dividends, or reduce debt.
3. Negative free cash flow may raise concerns about a company's financial stability and its ability to generate sufficient cash to meet obligations.
4. Investors often look at free cash flow as an important metric when evaluating a company's ability to sustain its dividend payments over time.
5. Free cash flow can also be used in valuation techniques, where it helps determine a company's worth by projecting future cash flows.

Review Questions

• How does free cash flow impact a company's ability to pay dividends and invest in growth?
  • Free cash flow is essential for a company's financial strategy because it represents the cash available after covering operational and capital expenses. A positive free cash flow indicates that a company can easily fund dividends, which can attract investors looking for income. Furthermore, it allows the company to reinvest in growth opportunities without relying on external financing, thus maintaining financial flexibility.
• In what ways can free cash flow be utilized in discounted cash flow valuation models?
  • In discounted cash flow valuation models, free cash flow is often projected into the future and discounted back to present value using a required rate of return. This approach allows analysts to estimate the intrinsic value of a company based on its ability to generate cash flows over time. By focusing on free cash flow rather than accounting profits, investors can get a clearer picture of the company's actual financial performance and its potential for growth.
• Evaluate the implications of consistently negative free cash flow on a company's long-term sustainability and market perception.
  • Consistently negative free cash flow can signal underlying issues within a company, such as declining sales or excessive capital expenditures. This situation can lead to concerns among investors about the company's long-term sustainability and its ability to meet obligations like debt repayments or dividends. Market perception may shift negatively, resulting in decreased stock prices and investor confidence. If not addressed promptly, ongoing negative free cash flow could hinder future growth prospects and diminish overall market attractiveness.

Related terms

capital expenditures: Funds used by a company to acquire, upgrade, and maintain physical assets such as property, buildings, or equipment.

discounted cash flow:

A valuation method that estimates the value of an investment based on its expected future cash flows, adjusted for the time value of money.

dividends:

Payments made by a corporation to its shareholders, usually in the form of cash or additional shares, representing a portion of the company’s earnings.