Free cash flow is an essential metric for investors, analysts, and businesses. It is a measure of a company's ability to generate cash after accounting for capital expenditures. In simple terms, it is the cash that a business has left over after paying for its operating expenses and investments. Free cash flow is an important indicator of a company's financial health and its ability to pay dividends, buy back shares, pay down debt, and invest in growth opportunities.
Finding free cash flow can be a daunting task for those who are not familiar with financial statements, but it is not as complicated as it may seem. In this article, we will explore the steps to find free cash flow and understand its importance.
Step 1: Understand the Formula
Before we dive into the details of finding free cash flow, let's first understand the formula. Free cash flow is calculated by subtracting capital expenditures from operating cash flow.
Free Cash Flow = Operating Cash Flow – Capital Expenditures
Operating cash flow is the cash generated from a company's operations, including sales, expenses, and working capital changes. Capital expenditures refer to the money spent by the company on buying or upgrading assets, such as property, plant, and equipment.
Step 2: Obtain the Financial Statements
The first step in finding free cash flow is to obtain the financial statements of the company. The financial statements include the income statement, balance sheet, and cash flow statement. These statements are available on the company's website or in the Securities and Exchange Commission's (SEC) EDGAR database.
Step 3: Calculate Operating Cash Flow
The next step is to calculate the operating cash flow. Operating cash flow is the cash generated from a company's operations, including sales, expenses, and working capital changes, such as accounts payable or accounts receivable.
To calculate operating cash flow, we need to use the cash flow statement. The cash flow statement is divided into three sections: operating activities, investing activities, and financing activities. We need to focus on the operating activities section, which shows the cash inflows and outflows from the company's operations.
To calculate the operating cash flow, we need to add back the non-cash expenses, such as depreciation and amortization, to the net income. We also need to adjust for changes in working capital, such as accounts payable or accounts receivable.
Operating Cash Flow = Net Income + Depreciation and Amortization – Changes in Working Capital
Step 4: Calculate Capital Expenditures
The next step is to calculate the capital expenditures. Capital expenditures refer to the money spent by the company on buying or upgrading assets, such as property, plant, and equipment.
To calculate capital expenditures, we need to use the cash flow statement. The investing activities section of the cash flow statement shows the cash inflows and outflows from the company's investments, such as buying or selling assets.
To calculate the capital expenditures, we need to look at the cash outflows from the investing activities section that relate to property, plant, and equipment.
Capital Expenditures = Cash Outflows for Property, Plant, and Equipment
Step 5: Calculate Free Cash Flow
Now that we have calculated the operating cash flow and capital expenditures, we can calculate the free cash flow.
Free Cash Flow = Operating Cash Flow – Capital Expenditures
Step 6: Analyze the Free Cash Flow
The final step is to analyze the free cash flow. Free cash flow is an important metric for investors, analysts, and businesses. It is a measure of a company's ability to generate cash after accounting for capital expenditures.
Positive free cash flow indicates that the company is generating more cash than it is spending on investments, which is a good sign. It means that the company has the potential to pay dividends, buy back shares, pay down debt, and invest in growth opportunities.
Negative free cash flow indicates that the company is spending more cash than it is generating, which is a bad sign. It means that the company may have difficulty paying dividends, buying back shares, paying down debt, and investing in growth opportunities.
Finding free cash flow is an important task for investors, analysts, and businesses. It is a measure of a company's ability to generate cash after accounting for capital expenditures. To find free cash flow, we need to obtain the financial statements, calculate the operating cash flow and capital expenditures, and analyze the free cash flow. Positive free cash flow is a good sign, while negative free cash flow is a bad sign. By understanding free cash flow, investors, analysts, and businesses can make informed decisions about their investments and financial strategies.