Free cash flow is the cash a company generates through its operations, once you take off the non-cash expenses, changes in working capital, and capital expenditures. Thus this is the cash “free” to distribution that a company can potentially invest back into the growth of the business.
| Aspect | Explanation |
|---|---|
| Definition | Free Cash Flow (FCF) is a financial metric that represents the amount of cash generated by a company’s operations after accounting for capital expenditures (CapEx) needed to maintain or expand its asset base. It reflects the cash available to the company for debt repayment, distribution to shareholders, investment in growth opportunities, or other strategic uses. FCF is a crucial measure of a company’s financial health and its ability to create value for shareholders. |
| Calculation | FCF is calculated using the following formula: FCF = Operating Cash Flow – Capital Expenditures – Operating Cash Flow (OCF) represents the cash generated from a company’s core operating activities, such as sales, production, and services. It can be found in the company’s cash flow statement. Capital Expenditures (CapEx) include investments in property, plant, equipment, and other assets necessary for the business’s ongoing operations and growth. CapEx can also be found in the company’s financial statements. |
| Importance | FCF is a critical financial metric because it measures the company’s ability to generate cash beyond its immediate operational needs. It provides insights into the company’s financial stability, growth prospects, and capacity to reward shareholders. A positive FCF indicates that the company has excess cash after funding essential operations and investments, which can be used for debt reduction, dividend payments, share buybacks, or strategic acquisitions. |
| Uses of FCF | – Debt Repayment: FCF can be used to pay down debt, reducing interest expenses and improving the company’s creditworthiness. – Shareholder Returns: Companies may use FCF to pay dividends to shareholders or repurchase their own shares, increasing shareholder value. – Investment in Growth: FCF can fund new projects, acquisitions, research and development, and other growth initiatives. – Financial Flexibility: Maintaining a positive FCF position enhances financial flexibility, enabling the company to navigate economic downturns or seize investment opportunities. – Valuation: FCF is a key factor in valuation models and helps determine a company’s intrinsic value. |
| Negative FCF | A negative FCF indicates that a company is not generating enough cash from its core operations to cover its capital expenditures. While occasional negative FCF may occur during periods of heavy investment in growth, persistent negative FCF can be a cause for concern, as it may lead to liquidity issues, increased debt, or the need for external financing. Analyzing the reasons behind negative FCF is crucial for assessing a company’s financial health. |
| Interpretation | High and consistent positive FCF is generally seen as a sign of financial strength and effective management. However, the significance of FCF can vary by industry and business model. – Comparing FCF to other financial metrics and industry benchmarks can provide a more comprehensive understanding of a company’s performance and financial health. – FCF analysis is often used by investors, analysts, and financial professionals to make informed investment decisions and assess a company’s ability to create shareholder value. |
In free cash flow, we trust
When you look at the financials of tech companies, be it Tesla, Amazon or any other so-called unicorn startups or tech company an interesting aspect is how bad they perform if you measure them in terms of the bottom line.
Indeed, when you look at revenue growth, many of those companies seem to be doing fine. Yet when you look at the net profit (the money left after you deduct all the expenses from operating the business plus tax and interests), you are left with nothing, if not a net loss.
Does it mean those tech companies are worth nothing if they are not able to have a net profit? Not necessarily but of course the bottom line is still an important metric. When we enter the startup and tech world, we often need other parameters to measure their impact, for a few reasons.
Ecosystems take time to build
Often, tech companies are opening up new spaces, industries and operate with new business models. Those industries, areas and business models are not stand-alone, and they often need several pieces to come together before a company can start being profitable.
Think for instance how Salesforce began to operate with – at the time – a new business model for enterprise SaaS, which relied on a subscription-based revenue model.
While Salesforce grew consistently and quickly in terms of revenues, it was unprofitable for quite some time:
Indeed, Salesforce 2018 finally posted a net income, after years of net losses. Today the SaaS business model has become the norm for most tech startups and massive industries.
Yet it took years to build a context that would allow a single company, like Salesforce to make a profit:
Growth over profitability
Another critical element is growth. As startups try to dominate a niche, space, industry, and marketplace, they emphasize growth rather than profitability.
In many cases, tech companies are not only offering new products but also adopting new business models that open up spaces that before didn’t exist. In this scenario, market domination becomes the rule.
Thus, metrics like user acquisition become the primary elements those companies focus on to judge whether the business is going in the right direction.
When you focus on growth, profitability will in many cases be affected negatively.
Thus, to build a more sustainable business model, often companies – that have been focusing on growth for years – will have to slow down a bit and allow their bottom line to keep up with the growth pace.
Free cash flow as a north star
If you look at Amazon’s financials in the early 2000s, you notice a negative bottom line. Indeed, Amazon, between 2001 and 2002, was operating with a net loss of over a hundred million dollars.
However, already in 2002, Amazon was generating cash from its operations.
Indeed, Amazon has been able over the years to create a built-in cash machine mechanism for its business model to generate a massive amount of cash independently from its profit margins:
Thus, if we were looking at Amazon purely from its bottom line, we would assume the company would not be worth much. Yet Amazon – at the time of this writing – is among the tech companies with the highest market capitalization in the world.
Amazon managed to disrupt several industries and grow at fast speed thanks to its cash conversion cycle and its ability to generate cash from its operations.
Do we need to forget about the bottom line?
When Google showed its numbers back in the 2000s not only it was a company growing at a fast speed; but it was also extremely profitable. Indeed, besides the year 2000; in 2003 Google had already passed the billion revenue mark and had over a hundred million in net profit.
The same applies to Facebook. When the company made its IPO back in 2012, it had already a billion in net profit and over three billion in revenues. Both companies would become the largest tech giants of our days.
They had created new businesses, and technologies, and operated new business models; yet they were highly profitable.
Thus, looking at the bottom line in combination with other metrics more focus on cash generation is still critical.
However, it is essential to make a critical differentiation.
When a company is not able to be profitable due to its inability to figure out a sustainable business model, that makes it way riskier than other companies that instead are not profitable because they decided to emphasize cash generation and growth.
In other words, the fact that Amazon chooses to keep its profit margin low is a strategic decision.
Compared to an upcoming startup, that instead is operating at a net loss only because it can’t figure out yet a business model. In the latter scenario, the bottom line still matters!
How does Amazon compute its free cash flow?
Example of how Amazon computes its free cash flows, from Amazon Q1 2020.
Key Takeaways
- Free cash flow is the cash generated by a company’s operations after deducting non-cash expenses, changes in working capital, and capital expenditures.
- Tech companies may perform poorly in terms of net profit despite strong revenue growth due to investments in new spaces, industries, and business models.
- Ecosystems take time to build, and profitability may take years to achieve as companies establish new contexts for their operations.
- Growth is often prioritized over profitability in the tech industry as companies aim to dominate markets and niches.
- Metrics like user acquisition and market domination become more important in judging the success of tech companies.
- Free cash flow becomes a crucial metric in evaluating tech companies’ sustainability and ability to generate cash independently from profit margins.
- Amazon is an example of a tech company that prioritizes cash generation through its cash conversion cycle, even with low profit margins.
- While profitability is essential, a focus on cash generation and growth can be strategic decisions for tech companies.
- Companies struggling to achieve profitability due to an unsustainable business model are riskier than those emphasizing cash generation and growth.
- Tech giants like Google and Facebook have demonstrated high profitability in combination with strong growth.
- Free cash flow is calculated as the cash generated from operations minus capital expenditures and changes in working capital. It provides insights into a company’s financial health and ability to invest in business growth.
| Related Frameworks, Models, or Concepts | Description | When to Apply |
|---|---|---|
| Free Cash Flow (FCF) | Free Cash Flow (FCF) is a financial metric that represents the cash generated by a company’s operations after accounting for capital expenditures necessary to maintain or expand its asset base. FCF is calculated by subtracting capital expenditures from operating cash flow and is considered a key indicator of a company’s financial health and ability to generate cash for debt repayment, dividend payments, and future growth opportunities. Positive FCF indicates that a company has surplus cash available for distribution to shareholders or reinvestment in the business, while negative FCF may signal financial distress or the need to reduce capital expenditures. | Apply Free Cash Flow analysis to evaluate a company’s financial performance and sustainability. Use it to assess the company’s ability to generate cash from its core operations, fund capital investments, and meet financial obligations, such as debt payments and dividend distributions. Implement Free Cash Flow forecasting and monitoring to assess future cash flow prospects, identify potential liquidity risks or opportunities, and make informed investment decisions, such as valuation, capital allocation, and strategic planning. |
| Discounted Cash Flow (DCF) Analysis | Discounted Cash Flow (DCF) Analysis is a valuation method used to estimate the intrinsic value of an investment by discounting its expected future cash flows to present value. DCF analysis relies on forecasting future cash flows, typically using Free Cash Flow projections, and discounting them back to their net present value using a discount rate that reflects the risk and time value of money. DCF analysis helps investors and analysts assess the attractiveness of an investment opportunity based on its expected cash flow generation and compare it to alternative investments. | Apply Discounted Cash Flow (DCF) Analysis to estimate the intrinsic value of an investment based on its expected future cash flows. Use it to evaluate investment opportunities, such as stocks, bonds, or projects, by assessing their potential for generating positive Free Cash Flows and delivering returns that exceed the required rate of return or cost of capital. Implement DCF analysis as a tool for investment valuation, decision-making, and portfolio management to identify undervalued or overvalued assets and make informed investment decisions that maximize shareholder value and achieve financial objectives. |
| Net Present Value (NPV) | Net Present Value (NPV) is a financial metric used to evaluate the profitability of an investment by comparing the present value of its expected cash inflows to the present value of its initial investment or cash outflows. NPV analysis considers the time value of money by discounting future cash flows back to their present value using a discount rate that reflects the investment’s risk and opportunity cost. A positive NPV indicates that the investment is expected to generate a return that exceeds its cost, while a negative NPV suggests that the investment may not be economically viable. | Apply Net Present Value (NPV) analysis to assess the profitability and feasibility of investment projects or business initiatives. Use it to quantify the value created or lost by an investment opportunity based on its expected cash flows and compare it to alternative uses of capital. Implement NPV analysis as a decision-making tool for capital budgeting, project evaluation, and resource allocation to prioritize investments that maximize shareholder value and align with strategic objectives and financial constraints. |
| Economic Value Added (EVA) | Economic Value Added (EVA) is a financial performance metric that measures a company’s ability to generate value for its shareholders by earning a return on invested capital that exceeds its cost of capital. EVA is calculated by subtracting the cost of capital from net operating profit after taxes (NOPAT), adjusted for the capital charge on invested capital. Positive EVA indicates that a company has created value for shareholders, while negative EVA suggests value destruction. EVA analysis helps companies assess their financial performance relative to their cost of capital and identify opportunities to improve value creation. | Apply Economic Value Added (EVA) analysis to evaluate a company’s financial performance and value creation. Use it to assess the efficiency and effectiveness of capital allocation decisions, measure the economic profitability of business units or projects, and incentivize managers to focus on value creation. Implement EVA as a performance measurement and management tool to align financial incentives with shareholder value creation and drive improvements in operating efficiency, capital productivity, and overall business performance. |
| Cash Flow Forecasting | Cash Flow Forecasting is the process of predicting a company’s future cash inflows and outflows over a specific period to anticipate liquidity needs, identify potential cash shortfalls or surpluses, and make informed financial decisions. Cash flow forecasting involves analyzing historical cash flow patterns, assessing future revenue and expense projections, and incorporating external factors that may impact cash flow, such as economic conditions, market trends, and regulatory changes. Cash flow forecasts help companies manage working capital, plan for capital expenditures, and ensure they have adequate liquidity to meet financial obligations. | Apply Cash Flow Forecasting to anticipate future cash flow needs and manage liquidity effectively. Use it to develop short-term and long-term cash flow projections, identify potential cash flow gaps or excesses, and implement strategies to optimize cash flow management, such as adjusting spending, financing, or investment plans. Implement Cash Flow Forecasting as a financial planning and decision-making tool to improve cash flow visibility, reduce financial risk, and enhance financial flexibility and resilience in uncertain and volatile environments. |
| Cash Conversion Cycle (CCC) | The Cash Conversion Cycle (CCC) is a financial metric that measures the time it takes for a company to convert its investments in inventory and accounts receivable into cash receipts from sales, minus the time it takes to pay suppliers for inventory purchases. The CCC provides insights into the efficiency of a company’s working capital management and its ability to generate cash flow from its core operating activities. A shorter CCC indicates that a company is able to cycle its working capital more quickly, while a longer CCC may signal inefficiencies in inventory management, accounts receivable collection, or accounts payable turnover. | Apply Cash Conversion Cycle (CCC) analysis to assess the efficiency of working capital management and cash flow generation. Use it to identify opportunities to optimize inventory levels, shorten accounts receivable collection periods, and extend accounts payable payment terms to reduce the CCC and improve cash flow efficiency. Implement CCC monitoring and benchmarking as a performance measurement and management tool to track working capital performance over time, compare against industry peers, and identify areas for operational improvement and cost reduction. |
| Working Capital Management | Working Capital Management is the process of managing a company’s short-term assets and liabilities to ensure it has sufficient liquidity to meet its operational needs and financial obligations. Working capital components include cash, accounts receivable, inventory, and accounts payable, which represent the cash flow cycle of a company’s operations. Effective working capital management involves optimizing the levels of these components to balance liquidity and profitability, minimize financing costs, and maximize cash flow efficiency. | Apply Working Capital Management principles to optimize the levels of short-term assets and liabilities to maintain adequate liquidity and cash flow stability. Use it to implement strategies to accelerate cash inflows, such as improving accounts receivable collection processes, and delay cash outflows, such as extending accounts payable payment terms, to enhance working capital efficiency and reduce financing costs. Implement Working Capital Management practices, such as cash flow forecasting, inventory turnover analysis, and credit risk management, to optimize working capital performance and support sustainable business growth and profitability. |
| Cash Flow Statement Analysis | Cash Flow Statement Analysis is the examination of a company’s cash flow statement to assess its sources and uses of cash over a specific period. Cash flow statement analysis helps investors and analysts evaluate a company’s liquidity, solvency, and financial health by analyzing its cash flow from operating activities, investing activities, and financing activities. Key metrics derived from cash flow statement analysis include Free Cash Flow, operating cash flow, and cash flow adequacy ratios, which provide insights into a company’s ability to generate cash, fund investments, and meet financial obligations. | Apply Cash Flow Statement Analysis to evaluate a company’s cash flow dynamics and financial performance. Use it to assess the quality and sustainability of cash flow generation, identify trends and patterns in cash flow behavior, and evaluate the company’s ability to meet short-term and long-term liquidity needs. Implement Cash Flow Statement Analysis as a due diligence tool for investment analysis, credit risk assessment, and financial decision-making to identify potential red flags or opportunities for value creation and risk mitigation. |
| Cash Flow Ratios | Cash Flow Ratios are financial metrics calculated from a company’s cash flow statement to assess its liquidity, solvency, and financial flexibility. Common cash flow ratios include the operating cash flow ratio, cash flow coverage ratio, and cash flow to debt ratio, which measure a company’s ability to generate cash from its core operations, cover debt obligations, and fund investments. Cash flow ratios provide insights into a company’s cash flow health and financial resilience by comparing cash flows to key financial obligations and investment requirements. | Apply Cash Flow Ratios to evaluate a company’s cash flow health and financial resilience. Use it to assess the company’s ability to generate cash from its core operations, cover debt payments, and fund capital expenditures, dividends, and other financial commitments. Implement Cash Flow Ratios as financial performance indicators and benchmarks to monitor cash flow trends over time, compare against industry peers, and identify potential liquidity risks or opportunities for operational improvement and risk mitigation. |
| Cash Flow Forecasting Models | Cash Flow Forecasting Models are quantitative tools and techniques used to predict a company’s future cash flows based on historical data, financial projections, and assumptions about future business conditions. Cash flow forecasting models may range from simple spreadsheet-based models to sophisticated financial planning and analysis software that incorporate scenario analysis, sensitivity analysis, and Monte Carlo simulation techniques. Cash flow forecasting models help companies anticipate cash flow fluctuations, assess liquidity needs, and make informed financial decisions to manage working capital, investment, and financing activities. | Apply Cash Flow Forecasting Models to project future cash flows and manage liquidity effectively. Use it to develop cash flow forecasts for different time horizons, such as short-term cash flow budgets or long-term cash flow projections, and scenario analysis to assess the impact of various business scenarios on cash flow performance. Implement Cash Flow Forecasting Models as decision support tools for financial planning, risk management, and strategic decision-making to optimize cash flow management and ensure financial stability and resilience in a dynamic and uncertain business environment. |
Free Cash Flow Case Studies
Connected Financial Concepts
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