Definition
The Free Cash Flow (FCF) formula is a financial indicator that measures the amount of cash a company can generate after accounting for capital expenditure such as buildings or equipment. It is calculated by taking the operating cash flow and subtracting the capital expenditure. This value is useful for understanding the financial health of a company and its ability to generate additional profits.
Key Takeaways
- Free Cash Flow Formula, or FCF, is a crucial financial metric that indicates the amount of cash a company generates after accounting for the capital expenditures required for daily operations. Thus, it’s a key indicator of a company’s financial flexibility and health.
- The formula for calculating FCF is Operating Cash Flow minus Capital Expenditures. This single value allows stakeholders to see how much ‘free’ cash a company has left to potentially distribute to investors after all its obligations are met.
- FCF is used by investors to have a glimpse into the actual profitability of a company, especially because it’s harder to manipulate under GAAP rules. Negative FCF can be an indicator of a company’s struggle to generate enough cash, while positive FCF may indicate a successful firm with potential for growth.
Importance
The Free Cash Flow (FCF) formula is crucial in finance because it measures the actual cash that a company can produce after spending the money required to maintain or expand its asset base.
This metric offers a true picture of a company’s financial health and profitability because 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 expenditure on equipment and assets.
It is an excellent indicator of a company’s ability to generate cash beyond its regular business operations, pay down debt, buy back stock, pay out dividends, or expand its activities.
Therefore, investors and creditors often scrutinize FCF while evaluating a company’s financial strength.
Explanation
The Free Cash Flow Formula (FCF) is a key financial indicator for businesses and investors, as it elucidates the amount of cash that a company generates which is available for distribution among investors after accounting for reinvestment in fixed assets and working capital. It is often considered one of the most accurate indicators of a firm’s profitability, as it is harder to manipulate than other metrics and takes into account the necessary reinvestments a company must make to maintain its growth.
This formula is commonly used by investors and financial analysts to assess a company’s performance, valuation, and prospects for future earnings. The application of the Free Cash Flow Formula is essential in making important financial decisions.
Companies use it to analyse and optimize their financial operations, whereas, investors and analysts use it to determine a company’s investment potential. The higher the Free Cash Flow, the better it is as it signifies a company’s ability to generate enough earnings to be profitable, pay off debts, reinvest in its business, and yield returns for investors.
A negative FCF, on the other hand, may indicate that the firm is struggling to generate sufficient cash and could face financial hurdles in the immediate future.
Examples of Free Cash Flow Formula (FCF)
Free Cash Flow (FCF) is calculated as operating cash flow minus capital expenditures. It depicts the cash that a company is able to generate after considering the money needed for maintenance or expansion of its asset base. Let’s look at three real-world examples:**Amazon Inc. (AMZN):** For the fiscal year ending December 31, 2020, Amazon reported operating cash flow of $05 billion and capital expenditures of $96 billion, which resulted in FCF of approximately $
09 billion. This indicated that Amazon had significant free cash to invest back into the business, pay dividends, reduce debt, or add to cash reserves.**Alphabet Inc. (GOOGL):** For the fiscal year of 2020, Alphabet Inc. (Google’s parent company) recorded operating cash flows of approximately $12 billion and capital expenditure of around $78 billion. This resulted in a FCF of approximately $
34 billion, pointing to a strong cash generation capacity and the ability to fund its operations, investments, and any potential expansions.**Apple Inc. (AAPL):** For their fiscal year ending in September 2020, Apple reported operating cash flow of $67 billion and used approximately $31 billion for capital expenditures. Therefore, Apple’s FCF was around $
36 billion, demonstrating robust financial health and the flexibility to manage unexpected expenses or business downturns.Please note that these numbers are approximations and rounded for simplicity, actual values may vary slightly.
FAQ: Free Cash Flow Formula (FCF)
What is Free Cash Flow (FCF)?
Free Cash Flow (FCF) is a financial metric that represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. It’s an important measure of a company’s profitability and financial performance.
What is the formula for Free Cash Flow (FCF)?
The formula for Free Cash Flow (FCF) is: FCF = Cash from Operating Activities – Capital Expenditures. Cash from Operating Activities can be found in the Statement of Cash Flows and Capital Expenditures (Capex) can be also found there under the Investing Activities section.
Why is Free Cash Flow (FCF) important?
Free Cash Flow (FCF) is a crucial measure for investors and analysts because it shows how much cash a company can return to its shareholders. It serves as an indicator of a company’s financial flexibility and shows business’s ability to sustain or grow its operations.
How to calculate Free Cash Flow (FCF)?
To calculate Free Cash Flow (FCF), you need to subtract the company’s Capital Expenditure from its Operating Cash Flow. Both of these figures can be found on the company’s Statement of Cash Flows.
Can a company have a negative Free Cash Flow (FCF)?
Yes, a company can have negative Free Cash Flow (FCF), which means the company is investing heavily in its future growth or it is not generating enough cash to pay for its expenses. This may not always be a bad thing, but it’s typically more favorable for a company to have a positive FCF.
Related Entrepreneurship Terms
- Operating Cash Flow (OCF): This is the cash generated from the regular operations of a business.
- Capital Expenditures (CapEx): These are funds used by a company to acquire, upgrade and maintain physical assets.
- Net Working Capital: This refers to the difference between a company’s current assets and current liabilities.
- Debt Repayment: This represents the cash that the company must pay back to its creditors over a specified period.
- Dividends Paid: These are the cash that is distributed to the company’s shareholders based on the number of shares they own.
Sources for More Information
- Investopedia: This is a reliable source for finance and investing concepts, including Free Cash Flow Formula.
- Corporate Finance Institute: This is a global institution that provides online financial modeling and valuation analysis certification programs. They also offer a lot of resources, including explanation of the FCF.
- The Balance: It is a trusted source that covers personal finance, investing, and financial news which includes information regarding Free Cash Flow.
- Accounting Tools: Accounting Tools is a comprehensive resource that provides certified continuing professional education (CPE) courses for CPAs. The site also provides articles, books, and lectures that cover a range of accounting topics, including the Free Cash Flow Formula.
