Explanation: About "Free Cash Flow"
We will also explain the differences from "cash flow" and how to calculate it.
<Table of Contents>
1. Introduction
2. What is Free Cash Flow?
3. Differences between Free Cash Flow and Cash Flow
4. How Free Cash Flow is Used
(1) Returns to Shareholders
(2) Improvement of Financial Health
(3) Investment in Business Growth
(4) Corporate Valuation
5. How to Calculate Free Cash Flow
6. Relationship between Free Cash Flow and Business Conditions
(1) When Free Cash Flow is Positive
(2) When Free Cash Flow is Negative
7. Summary
1. Introduction
"Free Cash Flow (FCF)" is the cash that a company has left to use freely after subtracting the "investment cash flow" required for business maintenance and growth from the cash generated through business activities.
It plays an important role in returns to shareholders, improving financial health, investing in business growth, and corporate valuation.
In this article, I would like to explain how free cash flow is used, how it is calculated, and how to interpret cases where free cash flow is positive or negative.
2. What is Free Cash Flow?
As mentioned above, "Free Cash Flow (FCF)" is the cash that a company has left to use freely after subtracting the "investment cash flow" required for business maintenance and growth from the cash generated through business activities.
Free cash flow is an important indicator that shows a company's financial flexibility and its capacity for shareholder returns and growth investments.
3. Differences between Free Cash Flow and Cash Flow
"Cash flow" is recorded in the "Cash Flow Statement (C/F)." The items recorded here are divided into "operating cash flow," "investment cash flow," and "financial cash flow."
To reiterate, "free cash flow" is calculated by subtracting "investment cash flow" from "operating cash flow."
It indicates the cash that a company can ultimately use freely, and it can also be said to show a company's ability to generate cash.
In other words, the "Cash Flow Statement" shows the "entire flow" of cash.
In contrast, "free cash flow" is an indicator that focuses on how much cash a company has left to use freely as a result of the cash flow.
4. How Free Cash Flow is Used
There are no set rules for how a company uses the free cash flow it has generated, but the main uses include the following:
(1) Returns to Shareholders
Companies can use free cash flow as a source of funds to pay dividends to shareholders or execute share buybacks.
Stable dividends and active share buybacks are attractive elements for shareholders.
Abundant free cash flow can be said to increase the sustainability of shareholder returns and expectations for increases.
(2) Improvement of Financial Health
If free cash flow is used to repay borrowings, a company can reduce its debt and strengthen its financial structure.
If interest-bearing debt decreases, interest payments also decrease, and a virtuous cycle of further improving cash flow can be expected.
(3) Investment in Business Growth
Free cash flow also serves as a source of funds for investments aimed at future growth, such as expanding existing businesses, developing new businesses, research and development (R&D), and corporate mergers and acquisitions (M&A).
If there is sufficient free cash flow, strategic investment is possible without relying on external financing.
(4) Corporate Valuation
Free cash flow also plays a central role in the "Discounted Cash Flow (DCF) method," which is a representative corporate valuation technique.
The DCF method is a concept of discounting future cash flows back to their present value, and it is a method widely used in M&A and stock investment decisions.
To do this, it is necessary to calculate the present value of the cash flow.
The present value of cash flow can be calculated using the following formula:
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Present value of cash flow = Future cash flow / (1 + discount rate) ^ n years later
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5. How to calculate free cash flow
We will introduce the formula for calculating free cash flow and a concrete simulation.
(1) Formula for calculating free cash flow
Free cash flow can be calculated using the following formula.
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Free cash flow = Operating cash flow - Investing cash flow
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On the cash flow statement, the investing cash flow includes more than just investments for maintaining business operations.
Therefore, please note that if the company is focusing on other types of investments, the above calculation may not yield an accurate free cash flow.
In such cases, a more accurate free cash flow may be calculated by subtracting investments in equipment for maintaining current business operations from the operating cash flow.
(2) Free cash flow calculation simulation
We will calculate free cash flow based on a concrete example.
For example, consider a case where there are 2 million yen in sales, 800,000 yen in purchases, and 200,000 yen in expenses.
The operating cash flow is as follows.
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Operating cash flow = 2 million yen - (800,000 yen + 200,000 yen) = 1 million yen
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Also, if 400,000 yen was used for equipment costs, the investing cash flow is 400,000 yen.
Free cash flow can be calculated as follows.
Free cash flow = 1 million yen - 400,000 yen = 600,000 yen
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Sales 2 million yen
Purchases 800,000 yen
Expenses 200,000 yen
Operating cash flow 1 million yen
Investing cash flow 400,000 yen
Free cash flow 600,000 yen
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6. Relationship between free cash flow and business conditions
The business situation of a company is completely different depending on whether the free cash flow is positive or negative.
Specifically, each is as shown in the figure below.
We will explain the situations when free cash flow is positive and when it is negative, respectively.
(1) When free cash flow is positive
When free cash flow is positive, it indicates a state where the cash generated by the company's core business (operating cash flow) exceeds the investments for business maintenance and growth (investing cash flow).
Also, if free cash flow is positive, it can be judged that there is financial leeway.
It is considered that the company has the capacity to repay loans, pay dividends to shareholders, buy back its own shares, and make further growth investments (M&A or new businesses) without relying on external financing.
Furthermore, if free cash flow is positive, it can be judged that the business situation is sound.
A company that consistently generates positive free cash flow can be evaluated as having high core business profitability and conducting efficient investment activities. It is judged to have high financial stability.
Also, an effect of improving corporate value can be expected from positive free cash flow.
This is because investors expect an increase in future returns as the company's funds are utilized effectively.
However, even if free cash flow is positive, if its level is decreasing year by year or is at a low level compared to competitors in the same industry, concerns about future prospects may arise.
Note that companies in the growth stage often invest aggressively, so free cash flow may temporarily become small, so it cannot be judged unconditionally.
In addition to the fact that free cash flow is positive, it is important to analyze its level, trends, and background.
(2) When free cash flow is negative
When free cash flow is negative, it can be said that the cash generated by the core business (operating cash flow) alone is not enough to cover the funds required for investment activities (investing cash flow).
A slump in operating cash flow can be considered as a factor for negative free cash flow.
This occurs when the earning power of the core business has declined, or when working capital has deteriorated due to delays in collecting accounts receivable or an increase in inventory.
However, free cash flow can also be negative for reasons such as active investment activities.
Even if operating cash flow is positive, free cash flow can become negative if the negative margin of investment cash flow is very large due to large-scale capital investment or M&A in anticipation of future growth.
In the case of a negative value, it is extremely important to identify the cause.
It is necessary to check the breakdown of the cash flow statement, determine whether operating cash flow is positive or negative, and analyze investment cash flow in detail.
If operating cash flow is also negative and borrowing is increasing through financing cash flow, there is a high possibility that cash flow will become tight and affect the company's survival.
7. Summary
Free cash flow plays an important role in returns to shareholders, improvement of financial health, investment in business growth, and corporate valuation.
It is important to understand how to calculate and interpret free cash flow to appropriately grasp a company's situation.
Also, when analyzing free cash flow, the key is to check its breakdown in detail and to grasp the situation by looking at data for multiple years, not just a single year.
Reference: "freee" website
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