Free Cash Flow

Generally during an annual or quarterly earnings report, a company will indicate its Free Cash Flow (FCF) to investors and shareholders. Free cash flow is the amount of cash available after a company has paid its operations and other capital expenditure.

Usually, investors or shareholders will use the free cash flow as an indication of the company’s financial health, performance, well-being, and business model.

Companies can use the free cash flow to reinvest it back into the business to expand its operations, hire new employees, or invest in the development of newer products and services.

Free Cash Flow vs Net income

Free Cash Flow is the total amount of cash available after all deductions and operational costs have been covered.

To calculate free cash flow, a company would follow this formula:

Net cash from operations – Capital Expenditure = Free Cash Flow or FCF.

Net income on the other hand again refers to the company’s overall profitability. The net income is calculated as follows:

Total Revenue (Sales) – All costs and expenses = Net Income

Shareholders can use the net income as a way to measure whether a company is profitable for the long-term gain.

Free Cash Flow Limitations

FCF shouldn’t be the only metric from which a person or shareholder should determine the overall financial health of a business or company.

Limitations regarding FCF include:

  • FCF can be negative, while net income remains positive
  • Large payments or cash payments could mean that the FCF is positive, even if it still incurs high amortization expenses.
  • The free cash flow can indicate the overall health of the operational aspects of a business, not necessarily how well it’s doing.
  • Net income remains the best way to evaluate the financial well-being of a business.
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