What is free cash flow in simple terms?
Free cash flow indicates the amount of cash remaining after a company covers its capital expenditures (such as buying equipment or upgrading facilities). In simpler terms, it's the money left over after paying for all the essential investments needed to maintain and grow your business.
Free cash flow is one measure of a company's financial performance. It shows the cash that a company can produce after deducting the purchase of assets such as property, equipment, and other major investments from its operating cash flow.
Defining good free cash flow
But generally, a good FCF means you have enough money to pay your bills and day-to-day expenses for the month and still have cash on hand to invest in your business.
The best things in life are free, and that holds true for cash flow. Smart investors love companies that produce plenty of free cash flow (FCF). It signals a company's ability to pay down debt, pay dividends, buy back stock, and facilitate the growth of the business.
The formula would be: (Net Operating Profit – Taxes) – Net Investment in Operating Capital = Free Cash Flow. Subtract your required investments in operating capital from your sales revenue, less your operating costs, including taxes, to find your free cash flow.
Is cash flow the same as profit? Free cash flow is not the same as profit. Profit considers noncash items to represent the full financial performance during a specified time. On the other hand, free cash flow is the money the business has left over after paying all operating expenses and capital expenditures.
Free cash flow shows if a business is making enough money to maintain or grow itself, while still generating a profit. Free cash flow is a fairly technical accounting concept that is used mostly by lenders and investors.
A good price-to-cash-flow ratio is any number below 10. Lower ratios show that a stock is undervalued when compared to its cash flows, meaning there is a better value in the stock. This can be perceived as a signal to buy.
What it ultimately means is that free cash flow yield acts as a positive or negative indicator of how solvent or financially capable a company is, should the need arises to access cash quickly to take care of debt, other obligations, or in the event that the company needs to be liquidated.
- Hiring more employees.
- Repaying creditors.
- Acquiring another business.
- Opening another office.
- Paying dividends to owners and shareholders.
Which company has best free cash flow?
| FCF | D/E Ratio | |
|---|---|---|
| Apple (AAPL) | $108.81 billion1 | 1.872 |
| Verizon (VZ) | $13.83 billion5 | 1.566 |
| Microsoft (MSFT) | $72.66 billion9 | 0.1510 |
| Walmart (WMT) | $17.00 billion13 | 0.4614 |
Free cash flow is important for valuations because it provides key insights into a company's financial health, potential for growth, and ability to generate returns for investors.
It is also possible for a company to be profitable and not be able to grow, secure financing or attract investors. If the business goes out of cash, operations will sim- ply cease. This further illustrates why cash flows provide a better sense of the financial situation of a business.
In essence, while Free Cash Flow is a crucial metric for Warren Buffett, it's the holistic understanding of a business, its intrinsic value, and its price in the market that guides his investment decisions.
EBITDA stands for Earnings Before Interest, Taxes, Depreciation, and Amortization. It measures the company's overall financial performance and is often used as an alternative to other metrics, such as earnings, revenue, and income.
FCF is the money that remains after paying for items such as payroll, rent, and taxes, and a company can use it as it pleases.
Cash flow is the amount of cash and cash equivalents, such as securities, that a business generates or spends over a set time period. Cash on hand determines a company's runway—the more cash on hand and the lower the cash burn rate, the more room a business has to maneuver and, normally, the higher its valuation.
This means you may have a large portion of your cash, or profit, tied up in inventory. Rather than showing up as cash, you may now own your inventory outright, which will become more revenue and profit when you sell it, but in its current form you can't use it as you would cash – to pay bills or fund employee payroll.
Analysts favor free cash flow over earnings for valuations because it reflects actual cash generation, is less prone to manipulation, and is critical for investment decisions. It provides a clearer picture of a company's financial health and operational efficiency.
- FCFF – Free Cash Flow to the Firm.
- CapEx – Capital Expenditure.
- ΔWorking Capital – Net change in the Working Capital.
- t – Tax rate.
What does free cash flow look like?
Free cash flow can be calculated in various ways, depending on audience and available data. A common measure is to take the earnings before interest and taxes, add depreciation and amortization, and then subtract taxes, changes in working capital and capital expenditure.
Ans. Free Cash Flow Yield evaluates if the stock price of a company provides good value for the free cash flow being generated. When researching dividend stocks, usually, yields that are above 4% would be acceptable for further research. Yields that exceed 7% are considered of high rank.
EBITDA and free cash flow are two measures to evaluate a company's financial performance. Free cash flow measures a company's unencumbered cash flow at the end of the year, while EBITDA measures the earnings before taking account of taxes, loan interest, and other essential expenses.
Typically, the average P/E ratio is around 20 to 25. Anything below that would be considered a good price-to-earnings ratio, whereas anything above that would be a worse P/E ratio. But it doesn't stop there, as different industries can have different average P/E ratios.
Alphabet(Google)'s Free Cash Flow per Share for the trailing twelve months (TTM) ended in Dec. 2024 was $5.77. Hence, Alphabet(Google)'s Price-to-Free-Cash-Flow Ratio for today is 33.53. During the past 13 years, Alphabet(Google)'s highest Price-to-Free-Cash-Flow Ratio was 43.15.
