1.3 Free Cash Flow
A corporation’s value is dependent, in large part, on the income and cash flow it produces. Cash flow is different from income in that “income” is based on “accrual accounting,” which is transaction-based, and will reflect certain non-cash events such as depreciation, and other idiosyncrasies. One key idiosyncrasy has to do with “timing” – the accountant may book a sale, for example when “constructively received,” i.e., when legally and economically receivable, but not yet received in actual cash.
Under accrual accounting, the accountant records economic transactions rather than the movement of actual cash received and paid out; this results in “timing” differences between the two approaches. (In theory, in the long run, such accounting vs. cash differences even out.) Because of these differences, financial analysts who are more cash-oriented must make certain adjustments to the accounting data in their own calculations and projections.
In a certain sense, cash flow is more important to corporate valuation than income because dividends are (usually) paid out to investors in cash. Further, when engaging in corporate planning, a possible capital investment will be judged attractive dependent upon the cash flow it produces in the future because it is cash that, arguably, fuels growth.
Capital investments, i.e., “growth” investments, include expenditures for hard assets, as well as for product development, and much more. “Free cash flow” refers to funds that a project, or the corporation as a whole, generates beyond its own internal and ongoing needs. We may think of free cash flow as the cash which is left over from an investment project, after all net operating funds generated by the project are utilized for necessary, non-discretionary purposes, including hard assets’ maintenance and replacement, and increases in working capital; this “left-over” amount may be used for other financial purposes, such as fixed asset expansion, at the discretion of management.
The purpose of projecting the firm’s FCF is to get a handle on the firm’s future growth prospects after paying for non-discretionary capital and other expenditures. The more FCF the firm generates, the greater the firm’s growth prospects, the greater its management discretionary alternatives for choosing still further growth-oriented investment projects. It is, after all, growth which drives share price appreciation. We assume that the firm has a never-ending appetite for growth.
As it is true for the corporation, so too would it also be true for any individual capital investment project. The corporation will favor any specific investment project that provides maximum FCF.
What can the corporation do with its FCF?
- Purchase more P, P , & E, and expand its inventory
- Invest in Mergers and Acquisitions (using shares when high-priced)
- Increase Research & Development
- Pay discretionary (common stock) dividends
- Buy back common shares (when the shares are cheap)
- Pay off Debt
Once again, a project that throws off “a lot” of FCF is desirable. A firm, as a whole, that produces lots of FCF may be thought of in a most positive light – as one, among other possibilities, that has a lot of growth potential and makes for a good investment.
For information regarding the calculation of Free Cash Flow, please refer to the Introduction to Financial Analysis text by this author.