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What is free cash flow?

Free cash flow is the amount of money a company generates in its normal business operations. It includes expenditure for non-recurring capital assets.

Another way of looking at free cash flow is as the money that is available to the company to meet its expenses and pay dividends to shareholders.

Cash is itemised on the balance sheet under current assets. The statement of cash flows details cash in and cash out, from which it can be determined if cash flow is negative or positive (net change in cash account).

If you want to know what a company is spending its funds on, this is where the information should be. Current assets are defined as assets that can be liquidated within the year.

Free cash flow quick facts

Usage type:

Liquidity

Formula:

free cash flow (FCF) =  cash from operations – capital expenditure

free cash flow per share (FCFps) = FCF / shares outstanding

How to interpret free cash flow

Free cash flow should be used judiciously because there is no direct correlation between free cash flow (FCF) and share price.

Positive free cash flow means that a company has the resources to invest in new opportunities and generally grow the business. A large positive cash flow is desirable.

FCF is best viewed of a series of annual data points.

halfords 5-year fcf

How depreciation affects cash flow

Depreciation can be a big factor in appearing to distort the reading from year to year – cash flow accounts for investment all at once without allowing for depreciation. Also, although depreciation attracts tax allowances it is nevertheless treated as a non-cash item.

So an investment at Year 1 is recognised in cash flow (debit entry on non-current assets depreciation account), which means that the following year when the plant and equipment is on stream in the subsequent year the cash flow gets an artificial bump when depreciation is recognised on the Year 2 income and cash flow statements and the balance sheet.

Free cash flow can provide an important early-warning sign of problems in the business before they show up in earnings per share.

What is free cash flow per share and free cash flow to equity?

In addition to just looking at FCF in absolute terms, we can compare it against equity, using the free cash flow to equity (FCFE) formula:

FCFE = net income + non-recurring expenses – non-operating income + non-cash operating expenses – equity reinvestment

With this investors can also derive the free cash flow yield (FCFY), defined as:

FCFY = Free cash flow to equity (FCFE) per share / market price per share.

This lesson calculates free cash flow and free cash flow per share

What is the optimum free cash flow reading?

There is no set optimum range for free cash flow.

A free cash flow yield of 0.5 to 1.0 is considered optimum. Free cash flow yield = free cash flow to equity (FCFE) per share / market price per share

How to use the free cash flow ratio

This lesson makes use of the Stockopedia platform’s screener and other tools but these are not essential for successful completion of the lesson.

Halfords annual report, 2 April – go to the balance sheet (under accounts if using Stockopedia) to find the data you need.

free cash flow (FCF) =  cash from operations – capital expenditure

Go to the cash flow statement and find cash from operations and capital expenditure (see screenshot below):

cash from operations = 192

capital expenditure = 33.6

halfords free cash flow

Calculate free cash flow:

192 – 33.6 = 158

Halfords has a free cash flow of 158

Calculate free cash flow per share:

FCF per share = 158 / diluted number of outstanding shares (199).

Outstanding shares can be found at the bottom of the balance sheet (see screenshot below):

halfords outstanding shares

158 / 199 = 0.79

Halfords FCF per share = 79p

Go to the Stockreport section of Stockopedia and check the free cash flow per share data (see below):

halfords fcf per share