Free Cash Flow represents the amount of excess cash generated by a company which can be used to pay back debt, invest in new business opportunities or to enrich shareholders in the form of dividends or stock repurchases, without hurting current business operations. Therefore it is one of the most important indicators when you are analysing a company.
You can calculate a company’s Free Cash Flow as followed:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
Operating Cash Flow is basically the money a company earns with their regular business operations in a given year.
Capital Expenditures, which is also often called CapEx are expenses used to invest in physical assets such as property, plant and equipment. These expenses are essentially necessary for the company to maintain or expand business operations.
Many stock analysts see Free Cash Flow as one of the best forms to analyse the profitability of a company. This is because it is hard to influence Operating Cash Flow with creative accounting tricks, while earnings per share can be manipulated.
Note that a negative Free Cash Flow is not necessarily bad. It could be a sign that a company is investing heavily, which can produce higher returns in the future. It is for example quite common for smaller companies to have a negative Free Cash Flow as they are heavily investing to grow the business as fast as possible. Therefore, we advise you to look at the Free Cash Flow of the past 5 to 10 years and see the trend of Free Cash Flow over these years. If a company is consistently producing negative Free Cash Flow, it should be interpreted as a warning sign.