Learning Outcomes
- Calculate free cash flow
Free cash flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets.
The formula for free cash flow is:
[latex]\text{operating cash flow}-\text{capital expenditures}[/latex]
Assume the following statement of cash flows for Jonick Company:
| Subcategory, Cash flows from operating activities | ||
| Net income | $ 248,000 | |
| Adjustments to reconcile net income to net cash provided by operating activities: | ||
| Depreciation and amortization | 35,000 | |
| Increase in current assets | (36,000) | |
| Increase in current liabilities | 33,000 | |
| Gain on sale of investments | (137,000) | |
| Total adjustments | (105,000) | |
| Net cash from operating activities | Single Line | Single Line $ 143,000 |
| Subcategory, Cash flows from investing activities | ||
| Purchase of property, plant, and equipment | (144,000) | |
| Net proceeds from sales and purchases of investments | (20,000) | |
| Net cash used in investing activities | Single Line | Single Line (164,000) |
| Subcategory, Cash flows from financing activities | ||
| Long-term borrowing | 83,000 | |
| Dividends paid | (20,000) | |
| Net cash used in financing activities | Single Line | Single Line 63,000 |
| Net increase in cash and cash equivalents | 42,000 | |
|---|---|---|
| Cash and cash equivalents at beginning of period | 331,000 | |
| Cash and cash equivalents at end of period | Single Line $ 373,000 Double Line |
|
| Supplemental information: | ||
| Cash paid for interest | $ 55,000 | |
| Cash paid for income taxes | $ 66,000 | |
Free cash flow would be negative $1,000 (143,000 operating cash − 144,000 capital expenditures).
Because FCF accounts for investments in property, plant, and equipment, it can be lumpy and uneven over time. Just looking at the balance sheet, we see that Buildings (net of accumulated depreciation) increased significantly from 2018 to 2019. Also, although the mortgage note payable did not increase, the company issued bonded indebtedness that increased cash and may have been used to purchase a new building.
As you can see, metrics like this don’t often give the whole picture. They are most useful to identify hot spots, trends, and opportunities.
For example, take a look at this information for Ford Motor Company:
See the operating activities long description here.
Notice net income (before any extraordinary items) has dropped from $7 billion to $84 million. However, after adjusting from accrual basis to cash, operating cash flows have stayed fairly constant (the gray bar in the figure below).
See the net operating cash flow long description here.
In addition, the company invests in fixed assets at a fairly constant pace:
See the capital expenditures long description here.
And so, Free Cash Flow is also fairly constant, ranging from $9 billion in 2015 to $10 billion in 2019.
See the free cash flow long description here.
Free Cash Flow by itself, as with any metric, won’t tell you the whole story. In this case, we can see that Ford Motor Company has cash to use for dividends, debt payments, and other things in addition to reinvesting in capital assets, but we don’t know for sure if that is adequate. We’ll have to look at a much larger picture of the company to determine that.
Variations on Free Cash Flow
A variation of Free Cash Flow subtracts dividends from cash flows from operating income as well as capital expenditures. The resulting number would represent cash available for debt repayment and expansion. You probably wouldn’t want to compare one company’s Free Cash Flow computed after dividends with another company that computes a more traditional FCF, but for an intra-company analysis over time, you could use whichever measure makes the most sense, as long as you are consistent.
Investment bankers and analysts who need to evaluate a company’s expected performance with different capital structures will use variations of free cash flow like Levered Free Cash Flow which is adjusted for interest payments and borrowings, and Free Cash Flow per Share. Some investors calculate a quick estimate of Free Cash Flow by simply adding depreciation expense back to net income to get a rough estimate of cash from operations and from that, they subtract capital expenditures. Again, if all you are looking at is trend analysis, or if you are comparing companies using the same methodology for each, this quick method may be adequate. In any case, it is important to know exactly what you are comparing.
PRACTICE QUESTION
