What is free cash flow?
Put simply, it's the money a company has left after paying its expenses (operating expenses) and making the investments needed to keep the business running (capital expenditures). In other words, it tells you how much cash a business has available once the company has paid rent, salaries, and raw materials and made the investments needed to sustain its operations. That remaining money is what's known as free cash flow.
FCF serves several purposes, such as distributing profits to shareholders or the company's owners, paying down debt, or reinvesting in the business to expand it. It's important here to distinguish between capital expenditures, which are what we referred to when we talked about the investment needed to keep the business running, and reinvestment in the company.
Capital expenditures are essential for a business to keep operating, whereas reinvestment in the business is spending to improve productivity or expand the company, for example.
Imagine a company that prints books and has two machines in its factory. Operating expenses would be those for maintaining, repairing, or replacing the machines, whereas reinvestment would be buying a third machine or a second factory.
Why is FCF so important?
With that said, we need to put into context how important free cash flow is when valuing a company and understanding its financial health, something essential in any M&A process or in due diligence on the financials.
FCF shows a business's ability to generate cash on its own, which allows it to be financially stable. If free cash flow is positive, the business is generating more cash than it needs to sustain itself. That's an encouraging sign, because it points to a profitable business with room to expand.
On the other hand, a negative FCF indicates that the company needs more money to sustain itself than it is generating. That said, FCF can turn negative on a one-off basis if operating expenses have risen for a specific reason, such as a major breakdown or the replacement of expensive machinery.
To get a better view of free cash flow and interpret it more objectively, ideally you should look at this figure over the last several fiscal years, not just the most recent one. Data from the last five years will give you a more accurate assessment.
How is FCF calculated?
The formula is simple, but there are two key elements you need to know to calculate free cash flow: operating cash flow, which is the cash generated by the business's operations, and capital expenditures, or CAPEX.
The formula is: operating cash flows – (capital expenditures + operating expenses).
Why should every company calculate FCF?
Concepts like this are often assumed to be meant for large companies. Nothing could be further from the truth: FCF can and should be calculated by every company, regardless of its size.
Knowing how much money is left after covering operating and capital expenditures is essential to measuring the business's financial muscle. If FCF is positive, it tells you how much cash you have and whether it can be used to build liquidity as savings, to reinvest and grow, to pay down debt, or to take profits. Most often, it's used for several of these purposes
A key metric for valuing a company
Discounted cash flow (DCF) is one of the most widely used methods for valuing a company in an M&A process, along with EBITDA multiples. This method values a company based on its ability to generate free cash flow in the future.
To do this, in addition to the FCF we've discussed, you also need to factor in the discount rate. This rate reflects the risk of the project or company and is used to discount future cash flows to the present. The discount rate is usually based on the weighted average cost of capital (WACC), which combines the company's cost of equity and its cost of debt.
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