4.04 – Mastering The Meaning of “Free Cash Flow”
Understanding Free Cash Flow
The term “free cash flow” has become common in finance and investing. Despite its widespread use, it lacks an official definition from authoritative accounting or financial institutions and doesn’t appear in official cash flow statements.
Free cash flow is often mentioned in financial publications and by investment analysts, but its meaning can vary. Generally, it relates to cash flow from operating activities, but the specifics can differ.
Definitions of Free Cash Flow
Net Income Adjusted for Non-Cash Expenses
Net income plus depreciation and amortization expenses, as well as other non-cash expenses.
Cash Flow from Operating Activities
Cash flow from operating activities as reported in the cash flow statement. Using the term “free cash flow” suggests a distinction from this straightforward definition.
Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA)
EBITDA ignores cash flow effects of changes in short-term assets and liabilities involved in sales and expenses, and it overlooks that interest and tax expenses are typically paid in cash.
It’s important to clarify which definition is being used in any given context, as misunderstandings can lead to inaccurate assessments of a business’s financial health.
Practical Definition and Example
A practical and useful definition of free cash flow is:
Free Cash Flow=Cash Flow from Operating Activities−Capital Expenditures
This definition highlights the cash available after a business has made necessary investments in capital expenditures to maintain and grow its operations. For example:
$7.593 million (cash flow from operating activities)−$750,000 (capital expenditures)=$6.843 million (free cash flow)
However, caution is necessary when using this analysis. For instance, a technology company planning a significant acquisition in the next few years may show distorted free cash flow if it temporarily increases sales without making the necessary investments in new technology. In such cases, historical free cash flow figures might not accurately reflect future financial needs.
Free Cash Flow in Context
In many situations, cash flow from operating activities may not cover capital expenditures, leading businesses to borrow money, seek additional investments, or use cash reserves to bridge the gap. Despite having a cash deficit after capital expenditures, many businesses still distribute profits to owners, even when they don’t have free cash flow.
Key Considerations
- Variability in Definitions: lways clarify which definition of free cash flow is being used.
- Context Matters: Analyze free cash flow in the context of both historical and projected financial statements.
- Business Lifecycle: Young, growing businesses might not show free cash flow as they reinvest heavily, whereas mature businesses may generate consistent free cash flow.
By understanding these nuances, managers and investors can make more informed decisions based on a clearer picture of a business’s financial health and future potential.
