Free cash flow is the capital retained by a company after it has paid all its expenses, including building, rent, tax, payroll, inventory, etc. Companies may use the free cash flow for anything it sees fit.
Free cash flow is a true measure of a company’s profitability.
Businesses usually calculate free cash flow to take critical business decisions, such as whether to invest the money for expansion or to invest the money in ways to reduce the costs of operations.
Investors use the free cash flow metric to check the frauds in accounting, as these measures are stringent and less manipulable than net income and earnings per share.
Free cash flow also gives an idea to investors as to how much money can be used by a company for share buybacks and paying dividends to the investors.
There are numerous techniques for calculating Free Cash Flow, but they all provide the same results. It depends on which and how much data companies provide to determine the actual free cash inflow. Here are the equations that help the investors in calculating the free cash flow.
Free Cash Flow = Operating Cash Flow – Capital Expenditure
If a company does not provide operating cash inflow and expenditure data, then there are two more equations to calculate free cash flows. Here are the equations −
Free Cash Flow = Sales Revenue – (Operating costs + Taxes) – Required investment in operating capital
Free Cash Flow = Non-operating profit after taxes – Net investment in operating capital
Free Cash Flow shows the overall health of the business of a company. Good and financially sound companies usually have a healthy free cash flow which they can use to meet the needs of the business.
A good free cash inflow is an indication of a rising and well-doing business. Low free cash inflow figures show that there is a trouble or bottleneck in the business operations which must be addressed to stay competitive in the business.
Investors usually look for companies with high free cash flow figures, as this allows them to invest in promising companies that have good growth and prospects of rising.
Moreover, a company with good free cash flow can consider expanding or providing good dividends both of which are a good measure of the health of a firm.
A company with a healthy free cash inflow is good for new investors as well as those who are already invested in it. The ability of a company to meet all its business requirements and then have money left is surely a sign of good management and hence they are sought highly by investors.