As earnings season draws near, investors and analysts eagerly await financial reports from the companies in their watchlists to assess financial performance and growth trajectories so they can decide whether it’s the right time to commit more of their hard-earned cash or take some money off the table. One crucial metric that comes under the spotlight during this period is Free Cash Flow. Contrary to popular belief, profit and free cash flow are not the same thing given that profit refers to the company's revenue minus expenses, while free cash flow considers the actual cash available after accounting for various factors like capital investments and debt. In this article, we will delve into the concept of free cash flow and understand why it holds such significance during earnings season.
What Is Free Cash Flow?
Free Cash Flow is a financial metric that measures the amount of cash generated by a company's operations, available to be distributed to all stakeholders, including shareholders, debt holders, and reinvestment in the business. It provides valuable insights into a company's financial health, indicating its ability to generate cash after accounting for capital expenditures required to maintain or expand its asset base.
Importance of Free Cash Flow in Business
The free cash flow metric is an important tool used to assess a company's performance and sustainability as a business since it essentially represents the actual amount of cash available to a business. By comparing their current cash flow to that of prior periods, free cash flow allows businesses to compare their financial health over time and measure it against that of competitors. It can also be used to analyse trends related to profits earned versus invested capital over time.
How Is Free Cash Flow Calculated?
Now that we understand what is free cash flow, it's now crucial for us to learn how to calculate free cash flow. By looking at a company's cash flow statement, astute investors can obtain free cash flow numbers by subtracting capital expenditures from the operating cash flow. The free cash flow formula is as follows:
Free Cash Flow = Operating Cash Flow - Capital Expenditures
Free Cash Flow vs. Operating Cash Flow
While similar in name, it is essential to distinguish between free cash flow and Operating Cash Flow (OCF). OCF refers to the cash generated or consumed by a company's core operations. It excludes non-operating activities such as interest and taxes. Free cash flow, on the other hand, considers these non-operating elements and focuses on the cash available to the company beyond day-to-day operations.
How Free Cash Flow Can Be Used By Investors
From being a shorthand metric to understanding a company's financials to using it to compare its health across companies in a similar industry, here's how investors can use free cash flow numbers to gauge if it's worth investing in a specific stock or business.
Evaluating a Company’s Financial Health at a Glance
For investors, evaluating a company's free cash flow is crucial for determining its financial health and whether a business is worth investing in for the long haul. A positive free cash flow indicates that the company can cover its expenses, invest in growth and reward shareholders without solely relying on debt financing. This means investors won't need to fret about the business winding down its operations in the long run when taking into account threats like existing costs and expenditures.
Comparing Companies in the Same Industry
When comparing companies in the same industry, free cash flow provides a better picture of their relative financial performance. Using such a metric helps investors identify the most efficient and financially sound companies in a particular sector.
Challenges in Interpreting Free Cash Flow
Although the free cash flow formula seems easy to follow along, sometimes there can be snags in the road that can make interpreting free cash flow definitions challenging.
Seasonality and Cyclical Nature of Businesses
Many businesses experience fluctuations in cash flow due to seasonality or the cyclical nature of their industry. Thus, analysing free cash flow should take these factors into account to avoid misinterpretations of cash flow statements and balance sheets. For example, travel stocks are known for having more revenue during seasons of falling oil prices and vacation seasons. This will cause the free cash flow of travel companies during that specific season to be higher.
Capital Intensive vs. Non-Capital Intensive Businesses
Different industries have varying capital requirements. Capital-intensive businesses may have lower free cash flow due to significant investments in assets, while non-capital-intensive businesses might generate higher free cash flow. This is especially apparent when you compare the free cash flows of a tech startup against a mature company in the utility sector.
Impact of Debt and Interest Payments
Companies with high debt levels may allocate a significant portion of their cash flow to interest payments, impacting their free cash flow. This can be especially bad for a company's financial health in a high interest rate environment where debt becomes exceptionally costly. That's why it's essential to consider a company's debt structure when assessing free cash flow.
The Potential for Manipulation
Like many of the other metrics found on an audited financial statement, free cash flow is also prone to tweaking and adjusting so management portrays the desired image for their company. Investors should conduct thorough research, review audited financial statements and consider various factors when analysing a company's FCF.
Using Free Cash Flow During Earnings Season
Predicting Future Performance
By analysing the quarterly free cash flow of a company during earnings season, investors can gain insights into a company's future potential and growth prospects. Consistent positive free cash flow can be an indicator of a company's ability to generate long-term value. Conversely, negative free cash flow levels may imply that a company is struggling to achieve profitability or is spending excessively on achieving growth.
Identifying Potential Risks
A sudden decrease in free cash flow during earnings season may indicate underlying issues that could pose risks to the company's financial stability. While it's crucial to identify and address such risks promptly, investors should consider the trend of a company's free cash flow across multiple quarters. This is to avoid a potential panic-induced selloff because of one quarter of bad results.
Understanding Management's Strategy
Earnings season offers an opportunity to hear from company management. Analysing free cash flow alongside their statements helps investors understand the company's financial strategy and priorities. Even If free cash flow levels were to fall from the previous quarter, investors should not take this as a sign of a company's underperformance. Rather, investors should exercise due diligence and look further into what the funds were committed to. This can range from servicing debt obligations to mergers and acquisitions.
Free Cash Flow Comparison Example
To understand free cash flow levels better, let's take a look at a market leader like Tesla (NASDAQ: TSLA) in a growing industry like the electric vehicles sector.
Tesla has been reporting growing free cash flow levels in the past few quarters, growing from -US$0.316B in Q2 of 2021 to current levels of US$8.502B in Q4 of 2022. While the recent Q1 of 2023 might show a significant dip in free cash flow levels to US$441B, this might be due to the aggressive advertising efforts and potential expansion plans in Mexico and France that have been hinted at recently. Overall, the growing free cash flow levels showcase Tesla's consistent revenue growth and effective cost management, resulting in high operating cash flow. By capturing an increasing amount of market share in the electric vehicle space, Tesla can have a huge war chest of funds thanks to its healthy free cash flow levels. This can then be used to reinvest in new growth opportunities or service any long term debts.
The Bottom Line
Free cash flow is a critical metric that provides valuable insights into a company's financial health and performance. During earnings season, analysing free cash flow can help investors make informed decisions, identify potential risks, and understand a company's financial strategy better. By considering FCF alongside other financial metrics, investors can gain a comprehensive view of a company's overall health and prospects. Now that you know the ins and outs of what free cash flow is and how it reflects a company's fundamentals, you're one step closer to making some astute investment decisions of your own.
Keen to leverage upon the knowledge now that you're familiar with partially evaluating a company's fundamentals? Why not check out our guide to the best AI stocks and investing in renewable energy to put that knowledge to good use and begin your investing and trading journey with us today.