The Motley Fool

Investment Analysis Demystified: Free Cash Flow

Soldiering on with my investment analysis series of articles, this one will talk about free cash flow (“FCF”) and its importance. You can read about my previous articles on gross profit margin, operating margin and net profit margin here, here and here respectively. No doubt many readers may have seen me talk about the importance of investing in companies with strong balance sheets and FCF, but why exactly is FCF such an important concept, and what should investors look for?

First of all, let’s look at what FCF is. Free Cash Flow is defined by Investopedia as follows:

Free cash flow represents the cash a company generates after cash outflows to support operations and maintain its capital assets.

The formula would be written as such:

Operating Cash Flow – Capital Expenditure = Free Cash Flow

Capital expenditure or “Capex” represents the spending that a company needs to make to sustain its current operations (“maintenance capex”) as well as to grow the business (“expansionary capex”). In essence, FCF would represent the amount of cash which is left for the payment of dividends or accumulation on its balance sheet after the company spends on business development and maintenance.

Companies which generate consistent FCF are preferred over companies which do not, for the simple reason being that cash is the lifeblood of a company and would sustain its operations, employees and business activities.

Having positive cash flows also allows more flexibility for the company to decide on what to do with the cash – retain it for a rainy day, use it to buy-back shares to enhance earnings per share, or to pay some of it out as dividends to reward loyal shareholders.

The key word to look out for here is “consistent”. An investor should scan through a company’s five or ten-year financial history to ascertain if FCF was generated in all or most of those years. This attests to the stability of FCF generation and also lets the investor have more confidence when it comes to investing in the company, as the valuation would be backed by sustainable cash generation.

Of course, it is also important to assess if the company can continue to maintain good levels of FCF generation into the future, as this would support a sound investment thesis and probably also provide the investor with much-needed dividends.

The next article in this series will look at debt and its implications, and also how it can act as a double-edged sword for companies. [Editor’s note: The article on debt has been published and it can be found here.]

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.