What is Free Cash Flow and what is it for?

Free cash flow (FCF) is a fundamental concept in corporate finance that measures the liquidity available to a company after covering operating expenses and the investments needed to maintain or expand its production assets.

Understanding FCF is crucial for investors, analysts and managers, as it provides insights into financial health and the ability to generate value.

The Importance of Free Cash Flow

As just mentioned, the free cash flow represents the cash a company generates through its operations, net of capital expenditures and takes into account operating cash flow and capital expenditures

Operating cash flow includes all cash flows from the day-to-day operations of the business, while capital expenditures refer to investments in capital goods, such as machinery and equipment.

Its importance is essentially linked to the company's valuation. Investors use this indicator to evaluate the value of a company, if it is high it represents a good suggestion on the company's ability to generate liquidity, thus leading to a concrete opportunity to distribute dividends, buy back shares or to plan investments for growth.

In addition, companies that record a positive free cash flow have greater freedom to maneuver to address opportunities and challenges, being able to allocate capital to strategic projects, reduce debt or distribute profits to shareholders, not to mention that it can represent a clear signal of good management and financial stability. Otherwise, it can indicate liquidity problems or operational inefficiencies.

How to Calculate Free Cash Flow and the Factors That Influence It

The calculation of free cash flow can vary slightly depending on the source, but the basic formula remains the same: operating cash flow minus capital expenditures.

Specifically, operating cash flow is obtained from the balance sheet or cash flow statement. Suppose a company reports operating cash flow of €500.000. Capital expenditures are those expenses incurred for the purchase of capital goods. Suppose they are equal to €200.000. The final FCF is therefore €300.000 thousand.

There are several factors that can influence this indicator.

• Sales Growth: An increase in sales can lead to an increase in operating cash flow, thereby improving free cash flow.
• Operating costs: Similarly, a reduction in operating costs can increase free cash flow, as this variable impacts capital expenditures.
• Capital Investments: Significant investments in capital expenditures may temporarily reduce FCF, but may be necessary for future growth.
• Working Capital Management: Effective management of working capital (such as accounts receivable and inventory) can improve operating cash flow and vice versa.

The Limits of Free Cash Flow

Despite its undoubted usefulness, FCF has limitations that concern some aspects of the company. The first concerns variability, as this indicator can change significantly from one period to another due to cyclical investments or extraordinary expenses.

Another problem concerns the presence of inevitable external factors, such as economic crises or regulatory changes, which can impact cash flow regardless of whether the company is well managed or not.

Finally, one cannot blindly and exclusively rely on Free Cash Flow for the valuation of a company, and even in cases where it is positive it does not always guarantee good financial health and, in this perspective, it is essential to consider the general context and other financial indicators to have a more reliable overall vision.