What is Free Cash Flow? In Free Cash Flow We Trust

Business / By Gennaro Cuofano / March 16, 2024

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.

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Table of Contents

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:

what-is-saas — Software as a service (SaaS) is a model where a third-party provider hosts the infrastructure and applications and make them available through the Internet. This model leverages web-based software and on-demand applications that run centrally on the server of the provider, while the company purchasing the service will use those applications based on need and without the upfront cost.

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.

spotify-business-model — Spotify is a two-sided marketplace where artists and music fans engage. Spotify has a free ad-supported service and a paid membership. Founded in 2008 with the belief that music should be universally accessible, it generated €11.7 billion in 2022. Of these revenues, 87.4% or €10.25 billion came from premium memberships, while over 12.6% or €1.47 billion came from ad-supported members. By 2022, Spotify had 489 million users, of which 205 million premium members and 295 million ad-supported users.

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

is-netflix-profitable — Netflix is a profitable company, which almost $4.5 billion in net profits in 2022, slowing down compared to over $5 billion in earnings for 2021.

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.