Your Salary is 50,000 Rs. , Your expenses are 40,000 Rs. , 10,000 Rs. is your free cash flow. As its name suggests, Free Cash Flow means you are free to spend this cash anywhere you want. Mostly you will spend it on your development. You can join the Yoga Classes or some personality development courses or maybe you can learn a new language. So, in short, this free cash is the only thing that contributes to your development, apart from your expenses.
Let’s come back to the Stock Market.
Free Cash Flow = Cash generated from Operating Activity — Capex
What is Capital Expenditures(Capex)?: Capital expenditure, or CapEx, are funds used by a company to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment. CapEx is often used to undertake new projects or investments by the Company.
So, Free cash flow is the cash that is available for all the investors of the company. It represents the excess cash that a company is able to generate after spending the money required for its operation or to expand its asset base.
If a company is making earnings, it doesn’t mean that it can spend all the income directly. The company can only spend free cash. There is a crucial difference between ‘cash’ versus ‘cash that can be taken out of a business’, or in accounting terms: cash from operating activities and free cash flow (FCF).
The cash from operating activities is the amount of cash generated by the business operations of a company. However, not all of the cash from operating activities can be taken out of the business because some of it is required to keep the company operational. These expenses are called capital expenditures (CAPEX).
On the other hand, free cash flow is the cash that a company is able to generate after spending the money required to stay in business. This is the cash at the end of the year, after deducting all operating expenses, expenditures, investments etc and is available for distribution to all stakeholders of a company (Stakeholders include both equity and debt investors.)
Why FCF only?
The presence of free cash flow indicates that a company has cash to expand, develop new products, buy back stock, pay dividends, or reduce its debt. High or rising free cash flow is often a sign of a healthy company that is thriving in its current environment. Furthermore, since FCF has a direct impact on the worth of a company, investors often hunt for companies that have high or improving free cash flow but undervalued share prices — the disparity often means the share price will soon increase.
This is because earnings show the current profitability of the company. On the other hand, the free cash flow signals the future growth prospects of the company as this is the cash that allows the company to pursue opportunities to enhance shareholder’s value. Free cash flow reflects the ease with which businesses can grow or pay dividends to the shareholder.
How to analyze the free cash flow of a company?
While studying the cash flow of a company, it is important to find out where the cash is coming from. The cash can be generated either from the earnings or debts. While an increase in cash flow because of the increase in earnings is a good sign. However, the same is not true with debts.
Moreover, if two companies have the same free cash flow, it doesn’t mean that they have a similar future prospect. Few industries have higher capital expenditure compared to other industries. Further, if the Capex is high, you need to investigate whether the reason for the high capital expenditure is due to expenses in growth or expenditure. In order to learn these, you have to read the quarterly/annual reports of the companies carefully.
Negative FCF of a company.
A consistently declining or negative free cash flow of a can be a warning sign for the investors. Negative free cash flow is dangerous because it leads to slow down in the business. Further, if the company didn’t improve its free cash flow, it might lead to insufficient liquidity to stay in the business.
It is a measure of a company’s financial performance. Free cash flow represents how much cash a company has left from its operations i.e. the cash that could be used to pursue opportunities that improve shareholder value.
However, the absolute value of the free cash value doesn’t tell you the whole story. For proper selection of the stock, you need to go through proper analysis (Fundamental & Technical). Fundamental Analysis will tell you ‘ What to BUY’ and Technical Analysis will tell you ‘When to BUY’. You first have to find out where this cash is coming from and how the company is using it. Whether they are spending this money effectively on operations like giving healthy dividends, buybacks, acquisitions etc- or not. And finally, a consistent negative free cash flow of a company might be a warning sign for the investors.