"Free Cash Flow" is one tool that has been overlooked on this forum.
In recent times, "Free Cash Flow" has been getting a lot of attention from value investors.
Let me explain the concept in simple words.
There is a difference between the net profit reported by a company and the cash generated by the company.
The profit figure is reported in the "Profit & Loss Statement", but the cash generated is reported in the "Cash Flow Statement".
When we generally talk about "profit" we equate it with an increase in our cash position.
However, an accounting profit may not always mean an increase in cash levels for the business.
Some businesses are such that they need more and more assets as they grow.
It is obvious that investors will prefer a business that doesn't consume much cash to grow.
"Free Cash Flow" is a good indicator of how much of a company's cash is really "free" and
is not needed for daily operations and growth.
Cash flows are measured in different ways, but in order to avoid confusion, I will just use one formula here:
Free Cash Flow (for a firm) =
Net Profit
+ Depreciation and Amortization
- Change in Working Capital
- Capital Expenditure.
1. First, we take the net profit.
2. Then we add depreciation and amortization to it.
This is done because depreciation and amortization are non-cash expenses.
Even tough we deduct depreciation and amortization as expenses,
they do not lead to a cash outflow.
3. Then change in working capital is deducted. (If there is a
decrease in working capital, it will get
added to the first two items).
If some part of net profit is used up in increasing the working capital of the business, the cash levels will fall by the same amount.
We had seen in this thread on
ICSA India how an increase in debtors and an increase in other current assets had turned the cash flow negative.
One reason why jewelery stocks are being given low valuations may be because they constantly need to increase their working capital as their businesses grows.
4. We finally deduct capital expenditure. If cash is used to create a long-term asset, the cash levels will go down too.
Finally, just like earnings of a company shouldn't be taken at face value, "Free Cash Flow" also shouldn't be taken at face value.
From the same Investopedia article:
Quote:
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It is important to note that negative free cash flow is not bad in itself. If free cash flow is negative, it could be a sign that a company is making large investments. If these investments earn a high return, the strategy has the potential to pay off in the long run.
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Free Cash Flow
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