The cash generated by a company after accounting for capital expenditures such as building costs and equipment costs is called Free Cash Flow (FCF). This cash can be used for developing the company by using it for expansion, reducing debts, dividends, and other requirements. It gives a clear measure of the financial health of a company. FCF is instrumental in providing vital information to investors to derive the value of a firm and the value of its common equity. FCF valuation model techniques are used by investors and the net debt is subtracted from it to find the simple capital structure of the company’s equity structure.
An analytical view of FCF
The level of cash available to the investors of the company is measured by FCF.Stock Earnings is a company equipped with the best tools and services for calculating FCF. The total investment required after excluding the plant, property and equipment expenditures are known as capital expenditures along with any more expenditure that remain a concern for the company can be calculated by FCF. A careful scrutiny of FCF for a company opens gates to the funds which shouldbe transferred towards steps to enhance shareholder value.
An excess in cash can help in increasing the company’s development by expanding production, making acquisitions, reducing debts, paying dividends, and developing new products. An FCF that is high is an indicator of a financially healthy company with a strong balance sheet. However, negative FCF is not considered a bad phenomenon. It is possible that a company with a negative FCF can easily signify the company’s multiple investments. If these investments promise a high return on investment then they are beneficial for the company in the long run.
Preventions while calculating FCF
- The cash flow of the company can be calculated from the company’s cash flow statement. FCF depends on the state of the cash of the company which is in turn affected by the company’s net income. A significant amount of gains and expenses that have been made by the company which is not a part of the core business of the company, then they must be tactfully excluded from the cash expenditure calculations of the company. The normal cash generating capabilities of a company can be clearly gauged if the proper omissions are done.
- For most investors it is crucial to understand that companies can apply tactics such as delayed bill payments, lengthening the time to buy inventory and accelerated cash receipts to influence their FCF. Investors should scrutinize the leeway given by companies in terms of the inclusion of products and services in capital expenditures to make a fair comparison of the FCF of different companies.
Need for FCF
- As FCF is considered as a measure of the profitability of a company, investors usually opt for companies with high FCF with undervalued share prices. This indicates the fact that the share prices will soon increase in the market.
- FCF is a fundamental basis for stock pricing which the reason behind some people opting for FCF over EPS.