Free cash flow (FCF)

So what is all this stuff about free cash flow (FCF)?

 

Cash flow is critically important to the well being of a company - to make a rather obvious statement it is cash that pays the bills and dividends, not earnings. 

FCF is important because it is the amount of cash that is available from cash received after paying for:

operating costs, working capital, finance costs, tax and capital expenditure (capex)

to spend on:

repayment of debt (improving the creditworthiness of the business), acquisitions (non-organic form of growth), repurchase of its own shares (at the right price, value enhancing to shareholders) and dividends (income to shareholders).

So where is this information found?  You can go to a company’s annual report, which you will find on their company web-site, or visit Investegate, search for the company in question and seek out results announcements. 

Here is one from Advanced Medical Solutions (AMS)

CONSOLIDATED STATEMENT OF CASH FLOWS

	(Unaudited)	(Audited)
Year ended 31 December	2012	2011
	£'000	£'000
Cash flows from operating activities
Profit from operations	11,458	4,591
Adjustments for:
Depreciation	1,633	1,115
Amortisation - intellectual property rights	480	168
- development costs	125	85
- software intangibles	62	12
Decrease / (increase) in inventories	258	(936)
Decrease/ (increase) in trade and other receivables	923	(3,029)
(Decrease) / increase in trade and other payables	(2,740)	2,574
Share based payments expense	363	337
Taxation	(669)	-
Net cash inflow from operating activities	11,893	4,917
Cash flows from investing activities
Purchase of software	(380)	(812)
Capitalised research and development	(802)	(266)
Purchases of property, plant and equipment	(1,572)	(1,461)
Interest received	35	75
Acquisition of subsidiary	-	(53,130)
Net cash used in investing activities	(2,719)	(55,594)
Cash flows from financing activities
Dividends paid	(960)	(816)
Finance lease	(20)	(20)
Repayment of secured loan	(5,564)	(251)
New bank loan raised	-	20,921
Debt issue costs	-	(56)
Issue of equity shares	217	33,902
Shares purchased by EBT	(81)	(75)
Shares sold by EBT	44	72
Interest paid	(692)	(68)
Net cash from financing activities	(7,056)	53,609
Net increase in cash and cash equivalents	2,118	2,932
Cash and cash equivalents at the beginning of the year	7,122	4,122
Effect of foreign exchange rate changes	(399)	68
Cash and cash equivalents at the end of the year	8,841	7,122

 

The FCF of AMS is £8,482k (11,893+35-692-380-802-1,572), this compares to £2,385k in the previous year.  Some companies show interest cost & income within operating cash flow, so there will be no need to make any adjustment.

It is worth bearing in mind that sometimes, with capital intensive companies that are investing for future growth, you may need to make an estimate of maintenance capex and distinguish this from expansion capex.  A reasonable approach is to assume that the depreciation charge is equivalent to maintenance capex and the balance is expansion capex.  In these situations only maintenance capex is deducted from the operating cash flow to arrive at the FCF.  The expansion capex is then a use of free cash flow, rather like acquisitions, but organic.

Although short term numbers for FCF can be misleading, due to the cycle of funds through a business, over a period of say 3 years it becomes more meaningful and you can use FCF to compare to net income, it may highlight problems such as over optimistic valuations or accruals within the balance sheet or even manipulation by unethical management.  Also, since the valuation of a business is generally accepted as the discounted value of all future FCFs, its use in value investing is important.

If you want to short-cut all that number crunching, Morningstar provide a 5 year history of a company’s operating cash flow per share and capex per share so you can calculate their FCF per share.  You will find it under “Financials & Ratios” then “Cash flow” and its right at the bottom of the table.  The only minor shortcoming, is that due to the non-standardisation of interest costs & income, the operating cash flow per share may include or exclude interest, depending on how the company treats it.