What is Free Cash Flow (FCF)?
Before talking about the importance of FCF, let us see what is Free cash flow. Free cash flow is the quantity of the amount of cash that is generated by a business after the capital expenditures (for example, building, equipment, setup etc.) are accounted. This cash is in turn used for expansion of the business, for funds, reducing debts, paying employees, and other purposes.
The basic idea of generating free cash flow is for the expansion of the business. It is important, as it not only allows the business to expand, but also increases its value, gain more opportunities, and enhances shareholder value. The cash required to develop new products, reduce and ultimately pay off debts, make more acquisitions, and pay dividends.
The amount of cash available from all the operations to distribute the dividends to shareholders, debtholders, and all the investors after making all the priority-based and necessary investments to support the daily operations of the company. A company’s success and its value depend on the amount of FCF it can generate. The higher the FCF generated by a business, the more successful it is.
A Company can do following with Free Cash Flow (FCF)
- Payback the interest of the debts
- Pay off the principal amount of the debt
- Distribute and pay dividends
- Buyback stock
- Buying assets that are non-operating such as marketable securities, investing in other companies, etc.
Free cash flow offers a better measure to the investors and stockholders of a company’s fundamental performance. The free cash flow amount is considered one of the most accurate ways to indicate a company’s financial condition. Understanding a company’s FCF helps the management make the right decisions on future ventures that will improve the company’s shareholder value. In addition, having copious FCF also shows that the company is capable of paying its monthly dues. Along with these, any company can use its FCF to expand their business or even invest in short term plans.
Importance of Free Cash Flow (FCF):
Free cash flow is extremely important in the world of business. Compared to the earnings, FCF’s transparency exposes the company’s potential to grow and produce more profit and cash. In the meantime, there are usually other establishments looking to invest in a company that has an exceeding free cash flow. Typically, FCF is greatly used by other investors. FCF, compared to other measures of growth of a company, serves as an important and accurate basis for stock pricing. Coupling high FCF with low-valued share price and the investors can make great investments, profiting them.
Financial media tend to use the P/E multiples, i.e. the price to earnings multiple gives us very little insights about the company. FCF is an oversimplified metric used to rapidly estimate the future performance of the company. For example, in 2003, Amazon would regularly post its P/E multiple in 500s, but it was generating a negative FCF at the same time. Though the P/E multiple gave us uncertain information about Amazon’s future, the negative FCF generation gave us a clear picture. What the P/E multiple wouldn’t tell you is that in order for Amazon to support its other business operations, the investment rates of its profit back into its business must be higher. This information would be delivered accurately by measuring its FCF, which is why FCF is an important measure in the world of business.
