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How to Read an Earnings Report

Views 11KNov 14, 2023

Why free cash flow matters

Amazon founder Jeff Bezos once said: "Measure your company by your free cash flow."

Free cash flow is the cash available for a company to distribute in a discretionary way.

There are many ways to calculate free cash flow, one of the most common methods is subtracting capital expenditures from operating cash flow.  

Operating cash flow is the cash generated from a company's business operations.

It tells investors whether a company has enough cash flow to pay its day-to-day operating expenses, including buying materials, paying wages, and paying bills.  

Capital expenditures are upfront investments in fixed assets that are expected to fuel a company's future growth, such as spending on buildings and equipment.

In other words, free cash flow is the cash left over after a company pays its operating expenses and capital expenditures.

Free cash flow is one of the financial metrics investors care about most.  

Because it measures whether a company has enough cash remaining to pay creditors or distribute to investors.  

A positive free cash flow indicates that a company is capable of paying dividends, buying back shares, and reducing its debt.

Conversely, a negative free cash flow is when a company cannot generate enough cash to cover operating expenses and capital expenditures.

In this case, the company might need additional financing to support its business.  

So what is a good free cash flow?

Generally speaking, the higher the number, the better.

Because it indicates that the company is in a better position to pay its investors and grow its business, making it attractive to investors.

However it's important to note that an extremely high free cash flow may not be a good sign sometimes, as it may indicate that the company is not investing in its business properly.

In addition, companies operate differently from industry to industry.

For example, companies in the oil and gas industry usually have higher capital expenditures, as they have to invest heavily in fixed assets such as drilling equipment.

As a result, their free cash flow can be inconsistent over time.

To address the problem, some investors tend to use the overall trend of free cash flow to help analyze a company's financial health.

A stable free cash flow trend over the last few years may indicate that a company is in a relatively healthy position.

On the contrary, a falling trend could be a warning sign to investors for them to make further analysis.  

Free cash flow is the discretionary cash a company has.

It is an important financial metric that investors use to assess a company's financial health.

Disclaimer: This content is for informational and educational purposes only and does not constitute a recommendation or endorsement of any specific investment or investment strategy.

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