One of the single greatest tools you can use to determine the profitability of a company is Free Cash Flow. Free cash flow is a measure of a company’s cash after it has taken care of all expenses. It represents the money that a company can use to expand, improve, and advance.
You can easily calculate free cash flow by using statements of cash flows. These statements can be found on many investing websites, as well as the investor relations portion of any company’s website you’re researching. The equation used is simple:
Cash Flow from Operations – Capital Expenditures = Free Cash Flow
A good way of analyzing a company’s performance over time is to calculate the free cash flows over several years. By discovering trends, you can gather insight as to how a company has generated profits for specific periods of time.
Before a company can invest and make capital expenditures, it has to pay the bills. Free cash flow represents the cash that a company has after paying off all expenses. The “cash flow from operations” portion of the equation above is generated in statements by slightly altering net income. This means that when you look at a free cash flow number, you’re looking at a company’s cash after all expenses are paid and investments are considered.
You should also know that a negative, or low, free cash flow may not always spell trouble. Free cash flow can become negative if a company makes many capital expenditures. Capital expenditures are funds used by a company to obtain or improve assets. In other words, a low free cash flow can be attributed to a company’s investments.
So what does a company do with its extra cash? It can be used to increase shareholder in a number of ways. If deemed profitable, a company can use the extra profits to expand or diversify. It can increase the value of its stock by buying back stock at prices considered to be low. Companies can also use the cash to increase dividends. All of these options are incredibly beneficial to you as a current shareholder or potential buyer of stock.
Analysis of free cash flow should be a staple in your process of purchasing stock. Although it is a simple number to calculate, the knowledge you can gain from it is invaluable. You will instantly benefit by adding free cash flow to your arsenal of investing tools.
-Matt Schwartz
College Trillionaire
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