There are many important financial numbers that investors should look at when studying a company. One such number is free cash flow.
Free cash flow can be calculated by looking at the Cash Flow Statement of a company.
A simplistic way to calculate free cash flow would be to take the “Net cash from operating activities” figure under the “Cash flows from operating activities” section of the Cash Flow Statement and deduct the “Purchase of property, plant and equipment” figure under the “Cash flows from investing activities” section.
The names of the figures may differ from company to company, but they mean the same thing. For example, “Purchase of property, plant and equipment” may be named as “Acquisition of property, plant and equipment” for some companies.
Let’s say Company X generated net cash from operating activities of $200 million and used up $50 million to purchase property, plant and equipment. Its free cash flow figure would therefore be S$150 million ($200 million minus $50 million).
The free cash flow generated by a company can be used to reinvest in its own business, acquire other businesses, dish out dividends to its shareholders, buy back its own shares, or pay off debt. But without any free cash flow, a company has to either borrow money from banks, undertake private placements, or issue rights to its shareholders in order to obtain cash with which to sustain its daily operations.
Investors can use the free cash flow figure of a company to calculate different ratios and compare across different companies. One useful ratio would be the price-to-free cash flow ratio, which is calculated by dividing a company’s share price by its free cash flow per share. In general, a low price-to-free cash flow ratio is preferred over a high one.
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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P doesn’t own shares in any companies mentioned.