Benefits of Free Cash Flow And How To Calculate It
Free cash flow basically refers to the remaining amount of cash after a company pays for its expenses.
Financial experts also mention that free cash flow is one of the most useful metrics for investors. Smart investors are more interested in companies that produce a handsome amount of free cash flow.
A large amount of free cash flow is always a signal that a company has the ability to pay down debt, pay dividends, buy back stock, and facilitate the growth of the business.
In every company, the understanding of free cash flow is very important since it is one of the factors that affect the company procedures.
For starters, the financial department in every company should be able to calculate the cash flow as well as offer expert advice on how best they can manage such monies.
How To Calculate Free Cash Flow
You don’t have to be a financial guru to be able to do this kind of math. After all, there is always a formula for most of these mathematical calculations. Experts agree that there are several ways to calculate the free cash flow.
Some of the important factors to consider while at it include the nature of the audience as well as the data.
One of the most common measures is to take the earnings before interest and taxes multiplied by (1 − tax rate), add depreciation and amortization, and then subtract changes in working capital and capital expenditure.
A simpler formula by Investopedia indicates that from the cash flow statement, locate the item cash flow from operation (also referred to as “operating cash” or “net cash from operating activities”), and subtract the capital expenditure required for current operations.
Importance of Free Cash Flow
- Opens opportunities to enhance shareholder value.
Free cash flow allows for the development new products make acquisitions, pay dividends and reduce debt
- Some investors use it to measure a company’s financial performance.
Although it is very possible to measure a company’s performance by using net income, some investors prefer using free cash flow because it can hardly be manipulated.
- It a reliable measurement
The finance world is more inclined to accuracy other than guesswork. For this reason, free cash flow is regarded as one of the most trustworthy measurements because the evaluation of reported earnings is more accurate.
- Helps the company determine its fundamental value
Every day, investors compare stocks and one false estimate poses a risk of bad stock to end up looking good.
With the help of free cash flow, investors are able to have a close fundamental stock value which makes it easier for them to make better financial decisions.
- Even a negative cash flow is not a warning sign
It is important to understand that being on the negative is not bad for the company. That’s not how it works when dealing with free cash flow.
Negative free cash flow could be an indication that the company is making large investments. If there are high chances for the investment to result in a high return, then it is worth taking the risk.
- Can help you measure business’s growth and success
The good thing with free cash flow is that the company can be able to enjoy different options on how to use leftover money.
- Can be used to expand operations
Apart from funding some of the company’s operation, free cash flow can be used for investment as well as bringing additional employees on board.
Although there are many advantages around free cash flow, too much of it can indicate that the business does not have a proper grip on its assets.
Far from the benefits some of the disadvantages of free cash flow include; it cannot be good enough to solve every investor problem, it only works where there is visibility and has no benefit in long term investing.
Businesses can multiply their free cash flow by:
- Taking debts from creditors with lower interest rates and advance repayment schedules.
- Minimizing, limiting or delaying the company’s capital expenditure
- Improving the company’s financial strategy and business operations with management accounting.
According to Investopedia, just like all performance metrics, free cash flow has its limits.
On the other hand, provided that investors keep their guard up, free cash flow is a very good place to start hunting.