Alright, now let's discuss another analysis tool; it's called free cash flow. So I've got it labeled here as a ratio; it's not so much a ratio, but we use it in analysis in similar ways that we use ratios. So let's go ahead and dive in here. Free cash flow measures the cash that was earned from operations. In general, we're dealing with cash earned from operations here. So remember, we're dealing with cash here. Usually, we're dealing with numbers like income, net income, things like that. But now we're talking from a cash perspective. So when we look at our formula down here for free cash flow, we're talking about the first thing there, cash from operating activities. So where do we get cash from operating activities? Well, this is going to come from the statement of cash flows. Right? There are going to be 3 sections on the statement of cash flows: Cash from operating activities, cash from investing activities, cash from financing activities. Well, we want to focus on the operating activities. Operating activities, that's like our core business. From doing what we're supposed to do, how much cash are we able to generate from that business? And this cash from operating activities, like I said, is the company's cash-generating power. You can imagine that's a pretty important number. So we're going to take that cash from operating activities and we're going to reduce it for some things. It's for necessary investments in fixed assets. You can imagine, we're going to have to be buying new machines, we're going to have to be spending on buildings, whatever it is for our factories, whatever it is. We're going to be spending money pretty consistently on fixed assets, on long-term assets. And we might have necessary dividends that we need to pay to our stockholders to keep them happy. We might have some dividends that we could consistently pay. And we have to keep that up, right? So that's going to take away from our free cash flow. So remember, we're focused on cash in this situation. So once we take out these things, like these necessary investments, these necessary dividends, we're left with the free cash flow. Now, in this class, it's not so big of a topic, but I'll tell you, when you get to finance, free cash flow is going to be a huge topic that we talk about all the time. Because in finance, the focus is a lot more on cash rather than on income. So once you're taking a finance class, you're going to notice that the focus is always going to be on the cash rather than income. So income is more of an accounting concept, and finance is more focused on that cash. Cool? So here we have the formula. We've talked about it a little bit so far. And in this class, we're going to deal with it like this. We're going to take our cash provided from operating activities. It usually comes from a statement of cash flows, but if you have a multiple choice question, they're probably just going to tell you this amount or have you find it in some little bit of a roundabout way. Then minus capital expenditures. So capital expenditures, this is money you're spending on fixed assets, right? So some of that free cash flow, that money that you got from operations, you're going to have to spend it on the fixed assets. And then you might have to pay some dividends as well. So we'll take that out. For the most part, the free cash flow deals with the first two, but cash dividends are an important part of the calculation as well. So like I noted here, sometimes they ignore dividends. So you might want to double-check with your professor on how they're using the free cash flow formula. They might just have the first two and just not deal with dividends at all. But we're going to add it in there because if in the case that it's 0, if the professor doesn't talk about it, well, it's just 0, and you just leave it as 0. So how do we use free cash flow? Well, remember, this is focus on cash. And cash, well, remember, cash is king. Right? Cash is a big deal when it comes to actually making money. So it's the amount of cash generated to expand operations or to pay dividends. So this free cash flow, right? You could bring in cash by taking out a huge bank loan, but that's not sustainable, right? You're going to have to pay back the loan. You're going to be paying interest. This cash from operating activities, this is sustainable cash generation. And that's where we see a lot of the value of the company. Is being able to generate all this cash flow. All this cash coming in. Well, this is a good thing for investors to focus on. Now what if we see a negative free cash flow? This could indicate that the operating cash flows are bad, right? They're not high enough. We could say they're low. So if we have low free cash flows, low operating cash flows, what we might not be able to cover are fixed assets that we need to buy. We might need to take out a loan to buy those fixed assets. Or we might need to raise money from our stockholders to pay for those fixed assets. It'd be much better if we could just pay for those out of our operating cash flows, right? We generate enough cash to buy these things. However, a negative free cash flow might not all be bad, right? It could also mean that you're investing a lot. There's a lot of investment into fixed assets. You might still have some good operating cash flows. But you're expanding your business a lot. And you're buying a lot of fixed assets, so you can expand production. Well, this could mean that you're going to provide a lot of free cash flows in the future. You're expanding the business to be able to generate even more cash in the future. So a negative free cash flow in the current period might not be a bad thing. You want to analyze why it's negative. Is it because the operating cash flows are low? Or is it because you're investing a lot into fixed assets so that you can grow and be even more able to generate cash in the future? Okay? So in the end, it's a pretty simple formula, especially when you get it in a multiple-choice format. So let's go ahead and do some practice problems. Alright? Let's do it now.
Ratios: Free Cash Flow: Study with Video Lessons, Practice Problems & Examples
Created using AIFree cash flow (FCF) measures the cash generated from operating activities, crucial for assessing a company's financial health. The formula is: FCF=CashfromOperatingActivities-CapitalExpenditures-Dividends. Positive FCF indicates sustainable cash generation for expansion or dividends, while negative FCF may signal low operating cash flows or significant investments in fixed assets. Understanding FCF is essential for investors and financial analysis.
Ratios: Free Cash Flow
Video transcript
ABC Company's Statement of Cash Flows indicated the following:Cash Flows from Operating Activities $120,000; Cash Flows from Investing Activities ($80,000); and Cash Flows from Financing Activities $200,000. Other information includes the purchase of Land for $25,000 and Machinery for $15,000. During the year, ABC Company paid $10,000 in dividends. What is ABC's free cash flow?
XYZ Company uses the indirect method to calculate cash flows from operating activities. This year the cash flows from operating activities totaled $60,000. The company paid $10,000 in dividends and obtained a loan from the bank of $50,000. The company also purchased Equipment for $20,000 and Land for $10,000. What is XYZ's free cash flow?
Here’s what students ask on this topic:
What is free cash flow and why is it important?
Free cash flow (FCF) measures the cash generated from a company's operating activities after accounting for capital expenditures and dividends. It is crucial because it indicates the company's ability to generate sustainable cash flow, which can be used for expansion, paying dividends, or reducing debt. Positive FCF suggests strong financial health, while negative FCF may indicate low operating cash flows or significant investments in fixed assets. Understanding FCF helps investors and analysts assess a company's financial stability and growth potential.
Created using AIHow do you calculate free cash flow?
Free cash flow (FCF) is calculated using the formula:
First, find the cash from operating activities from the statement of cash flows. Then, subtract capital expenditures, which are investments in fixed assets. Finally, subtract any dividends paid to shareholders. The result is the free cash flow, representing the cash available for expansion, debt repayment, or other purposes.
Created using AIWhat does a negative free cash flow indicate?
A negative free cash flow (FCF) can indicate two main scenarios. First, it may suggest that the company's operating cash flows are insufficient to cover capital expenditures and dividends, signaling potential financial distress. Second, it could mean the company is heavily investing in fixed assets to expand its operations, which might lead to higher cash flows in the future. Therefore, while negative FCF can be a red flag, it is essential to analyze the underlying reasons to understand its implications fully.
Created using AIHow does free cash flow differ from net income?
Free cash flow (FCF) and net income are different financial metrics. FCF focuses on the actual cash generated from operating activities after capital expenditures and dividends, providing a clear picture of cash availability. In contrast, net income is an accounting measure that includes non-cash items like depreciation and amortization, reflecting the company's profitability. While net income is important for understanding profitability, FCF is crucial for assessing a company's liquidity and ability to fund growth or return value to shareholders.
Created using AIWhy do investors focus on free cash flow?
Investors focus on free cash flow (FCF) because it provides a clear indication of a company's ability to generate cash from its core operations. Unlike net income, which can be influenced by accounting practices, FCF reflects the actual cash available for expansion, paying dividends, or reducing debt. Positive FCF suggests financial stability and growth potential, making the company an attractive investment. Additionally, FCF helps investors assess the sustainability of a company's dividend payments and its capacity to invest in future growth opportunities.
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