Free Cash Flow

What Is Free Cash Flow?

Most people like to have some money left over after paying the bills--to take a trip, fix up the house, or save for a rainy day. Businesses are no different. But what we call mad money, they call free cash flow. It represents the cash a firm has generated for its shareholders, after paying its expenses and investing in its growth. Free cash flow is equal to total cash flow (earnings with noncash charges added back in) minus capital spending. Free cash flow can be very useful in assessing a company's financial health because it strips away all the accounting assumptions built into earnings. A company's earnings may be high and growing, but until you look at free cash flow, you don't know if the company's really generated money in a given year or not. If you're an owner, that's ultimately what you're interested in. Free cash flows represent real cash. Earnings do not.

Net income + Depreciation/Amortization
- Change in Working Capital
- Capital Expenditure
----------------------------
= Free Cash Flow



Is Free Cash Flow Foolproof?
Although it provides a wealth of valuable information that investors really appreciate, FCF is not infallible. Crafty companies still have leeway when it comes to accounting sleight of hand. Without a regulatory standard for determining FCF, investors often disagree on exactly which items should and should not be treated as capital expenditures. Investors must therefore keep an eye on companies with high levels of FCF to see if these companies are under-reporting capital expenditure and R&D. Companies can also temporarily boost FCF by stretching out their payments, tightening payment collection policies and depleting inventories. These activities diminish current liabilities and changes to working capital. But the impacts are likely to be temporary.

The Trick of Hiding Receivables
Let's look at yet another example of FCF tomfoolery, which involves specious calculations of the current accounts receivable. When a company reports revenue, it records an account receivable, which represents cash that is yet to be received. The revenues then increase net income and cash from operations, but that increase is typically offset by an increase in current accounts receivable, which are then subtracted from cash from operations. When companies record their revenues as such, the net impact on cash from operations and free cash flow should be zero since no cash has been received. What happens when a company decides to record the revenue, even though the cash will not be received within a year? The receivable for a delayed cash settlement is therefore "non-current" and can get buried in another category like "other investments". Revenue then is still recorded and cash from operations increases, but no current account receivable is recorded to offset revenues. Thus, cash from operations and free cash flow enjoy a big but unjustified boost. Tricks like this one can be hard to catch.