Free Cash Flow: A Simple Indicator of a Company’s Health

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One of the best indicators of corporate health is the Free Cash Flow (FCF) of a company and, unlike some other indicators, it is relatively easy to understand.

Think of FCF as the deposit you put in a savings account after paying your regular monthly bills. If this deposit keeps increasing, you should feel pretty good about the state of your finances. On the other hand, if your deposit starts shrinking or if you need to dip into your savings account just to tread water, you know some serious financial problems may be lurking just around the corner.

Corporations operate in much the same manner. First, like a paycheck, they generate cash from operating the business. This is called Operating Cash Flow (OCF). From this, they subtract their Capital Expenditures. Capital expenditures are expenses for capital equipment and other physical property, like real estate. What’s left over is their free cash flow.

The FCF can be used for several purposes, including paying a dividend, buying back stock, lowering debt, or saving for future acquisitions. Without FCF, a company will find it hard to grow its business without issuing new debt or diluting the stock. Except for start up corporations that will often show negative cash flow in their beginning years, free cash flow is a good indicator of a company’s ability to both maintain and increase its operations.

Remember, because cash flow analysis puts business activity on a “cash” basis, it can uncover problems even if a company reports positive earnings per share. Krispy Kreme is a recent example of this. Manipulation of earnings is a frequent problem on Wall Street and FCF can help keep everyone more honest.

This isn’t to say that FCF, itself, is not without problems. If a company refuses to replace aging equipment, free cash flow can be overstated. Of course, once the equipment is replaced, cash flow may take a violent dive. This, by itself, is a red flag indicating potential danger.

Some investors like to set up various ratios using FCF. By dividing free cash flow per share by the company’s current price per share, you’ll get a “free cash flow yield.” This is useful in comparing companies in the same industry. The higher the yield, the more favorable the stock.

Other investors solve for the “price to free cash flow multiple.” Here, you divide the share price by the free cash flow per share. This is somewhat similar to the familiar P/E ratio and, like the P/E ratio, you are looking for lower numbers.

If you simply want to skip all this, go to MSN Money on the internet and click on “Stocks.’ From there, go to “Statements” under “Financial Results.” Then, go to the “Cash Flow” statement. At the bottom of the page, you’ll see that MSN has done a lot of this work for you.

Happy Hunting.

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Source by Glenn Dahlke