Free Cash Flow: Lifeblood of Corporations

Before you invest heavily in stocks, you should really pore over the cash flow statement. I regard it as the bible, more important than the balance sheet or profit/loss statement.

Emphasizing on earnings alone is ill-advised as devious managements can window-dress results using accounting gimmicks. Cash flow is harder to fake and following the trail of “real” cash is what investors should be concern about. Cash flow statement gives a much clearer view of the ability to generate cash (and thus profits).

To understand the impact of upkeep and expansion on a corporation, we apply the concept of Free Cash Flow (FCF) which represents the cash that a company is able to generate after allocating for maintenance and asset expansion.

FCF = Net Income + Amortization/Depreciation – Changes in working capital – Capital Expenditures

or more simply, FCF = Cash flow from operations – Capital Spending

Capital spending in this case refers to money used to buy fixed assets.

Free Cash Flow

Without Free Cash Flow, a company is deprived of many opportunities that enhance shareholder value. It is tough to develop new products, make acquisitions, pay dividends, share buybacks and reduce debt.

The more Free Cash Flow is available, the more the owner can withdraw cash from the kitty without harming ongoing business, without depending on the whims and fancies of the capital markets.

A company that has negative free cash flow has to apply for loans or issue additonal shares to keep things going, and they can become risky in a market downturn. This could be a critical stage for the company which is moving into the next phase of expansion.

However, we should note that negative free cash flow is not bad in itself. If free cash flow is negative, it implies the compnay is aggressive in making large investments for future growth and when these investments start turning in high returns, the strategy has the potential to pay off in the long run.

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2 Comments

Filed under Business, Stocks

2 Responses to Free Cash Flow: Lifeblood of Corporations

  1. I’m very glad I found this post. I have emailed the link to a number of people who don’t see the critical importance. FCF is a crucial measure in valuation- it can’t be ignored. Thanks.

  2. Free cash flow is an important measure. It is true free cash flow being negative can be an indication of large investments in future growth. But that is not the only reason. GM’s huge negative cash flow is not from all the great investments they are making this year.

    John @ Curious Cat Investing Blogs last blog post..Financial Thanksgiving

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