Term
Free cash flow
The cash a company keeps from operations after paying for the investment needed to sustain and grow the business. It funds debt repayment and dividends and underpins a DCF valuation.
Updated
What it means
Free cash flow is the money a company has left from operations after paying for the investment needed to maintain and grow the business. Put simply, it is operating cash flow minus capital expenditure on fixed assets.
Unlike accounting profit, free cash flow reflects that the company must tie up money in stock and receivables, its working capital, and invest in machinery or technology. A company can report a profit yet have negative free cash flow if it is growing fast and investing heavily.
Free cash flow shows how much money is available for repaying debt, paying dividends or making acquisitions. It is the basis of valuing a company by discounted cash flow, DCF, in which future free cash flows are converted to present value.
How it works in practice
When planning with clients, we do not stop at profit. From the profit plan we derive a cash flow plan: when customer receipts arrive, when suppliers must be paid, what investment is planned. That shows how much free cash the company really generates month by month.
In a DCF business valuation, we work with a forecast of free cash flows several years ahead. The key is estimating revenue growth, margins, required investment and working capital changes sensibly. A small change in assumptions can shift the resulting value considerably.
For banks and investors, free cash flow is often more convincing than EBITDA, because it accounts for investment and working capital. A company with high EBITDA that must reinvest all its cash has nothing left to service debt or pay dividends.
What to watch out for
There is no single binding definition of free cash flow. Some calculate it before interest, others after; some include only maintenance capex. When comparing figures from different sources, always check how they were calculated.
Free cash flow can be improved in the short term by postponing investment or stretching supplier payments, but that weakens the company over time. When assessing it, look at the trend over several years and at how the result was achieved.
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