What's free cash flow?

Free cash flow (FCF) refers to cash inflow or outflow available by a company's management to either distribute to shareholders or reinvested into the business. In this article, we discussed this in detail.

1. Free cash flow explained

The term free cash flow refers to the difference between the operating activities and investing activities in a statement of cash flows. It is the fund available for use to maximize shareholders wealth, pay for debts, meet tax obligations, as well as to satisfy other stakeholders.

FCF is also explained as the net income less (non cash item, changes in current assets and liability), and capital expenditure. May be computed simply as net operating cash flow minus capital expenditure. The value is a measure of profitability of a company. However, it is different from profit before tax and profit before interest and depreciation. 

The computation of FCF is done based on cash basis accounting. Therefore making it different from other profitability computation methods such as earnings per share. A higher free cash flow implies that a company has the cash to meet future obligations. Such funds can either be reinvested into the entity's growth, pay dividends to investors, or meet debt obligations.

Potential investors can use the information to decide on investment in the company. If the company intends to get funds from banks or other financial institutions, the free cash flow can guide the bank to know if it should provide such borrowings to the company. More so, it can be used to determine if the directors are pushing the interest and objectives of the company ahead of theirs.

2. Differences between free cash flow and earnings per share

Free cash flow can be used as a ratio of the number of ordinary shares. This is referred to as unlevered FCF. Below we explain three differences between FCF and EPS.

2.1 Basis of accounting

The basis of computing free cash flow is the cash basis but for earnings per share, it is accrual basis.

2.2 Taxation

Company income tax is deducted to arrive at the earnings used in computing EPS but that's not so with FCF. Only the cash paid as taxes for the period are deducted in computing the value.

2.3 Main sources of computation 

FCF is computed using a statement of cash flow. However, where this is not available, a statement of profit or loss and other comprehensive income as well as a statement of financial position can be used. For EPS, it is computed from the statement of profit or loss.

3. Factors that can impede free cash flow

Generally, it is expected that the value for FCF is higher than profit after tax (PAT). However, this is not always the case. Here are some reasons why and as stated by investopedia. 

3.1 Business growth 

If cash is used for capital expenditure in a particular year, this will impede the available cash flow. For example, if the director acquired a solar system for the company worth 10 million Naira with an expected useful life of ten years, the total amount is deducted from the net operating income to arrive at the FCF. 

However, if the company's depreciation policy is a straight line method, only 1 million Naira will be deducted from the statement of profit or loss to compute the profit after tax. This will make the FCF to be lower than the PAT for that period.

3.2 Credit policies

The credit policy may have an impact on free cash flow. A company that has a flexible credit policy may have lots of accounts receivable. However, the periods in which creditors are requesting for their money with no funds received from debtors will impede the FCF value. 

3.3 Level of inventory

A company with high investment on inventory or those that have high inventory levels will experience lower FCF. This is because the available cash is being used to buy more inventories, thereby holding up funds that should be used for other business activities.

4. Conclusion

In summary, free cash flow refers to cash available to meet key stakeholders needs such as shareholders, creditors, and the government through the tax authority. It is computed by subtracting capital expenditure from net operating expenses. The value can be used by potential investors and creditors to access the profitability of the entity.