Free cash flow

Benefits of Free Cash Flow Analysis

FCF analysis offers valuable insights into a company's financial stability and trends. It accounts for changes in working capital, which can reveal:

• Shifts in vendor payment requirements
• Collection of cash from customers
• Changes in inventory levels

This information is crucial in understanding a company's overall financial health and identifying potential weaknesses.

Limitations of Free Cash Flow

Despite its advantages, FCF analysis has some limitations:

• It can be lumpy and uneven over time due to capital expenditures
• Depreciation methods can impact net income and FCF comparisons
• Not subject to the same financial disclosure requirements as other financial statement line items

Calculating Free Cash Flow

You can calculate FCF using the statement of cash flows or by reconciling items from the income statement and balance sheet. The two main approaches to calculating FCF are:

1. Using cash flows from operating activities, then adjusting for interest expense, tax shield on interest expense, and capital expenditure
2. Starting with earnings before interest and taxes (EBIT), then adjusting for income taxes, non-cash expenses, changes in working capital, and capital expenditures

How to Define Good Free Cash Flow

Defining good FCF is challenging, as many factors can influence the metric. Analyzing the trend of FCF over time is one approach to simplifying this task. By focusing on the slope of FCF and its relationship to price performance, investors can better gauge the stability of a company's financial health.

Real-Life Example of Free Cash Flow Analysis - Apple Inc.

Let's take a look at Apple Inc. (AAPL) as a real-life example of free cash flow analysis. We will examine their financials for the fiscal year 2020 to understand their FCF situation.

In 2020, Apple reported the following financial figures (all numbers in millions):

• Net Income: $57,411
• Depreciation and Amortization: $11,042
• Changes in Working Capital: $2,759
• Capital Expenditures (CapEx): $7,309

To calculate Apple's free cash flow, we'll use the following formula:

FCF = Net Income + Depreciation and Amortization - Changes in Working Capital - Capital Expenditures

Plugging in the numbers:

FCF = $57,411 + $11,042 - $2,759 - $7,309

FCF = $58,385

For fiscal year 2020, Apple had a free cash flow of $58.385 billion. This strong FCF indicates that Apple had substantial cash available for investing in growth, paying dividends, or repurchasing shares. A positive and growing FCF is an attractive feature for investors, as it shows the company's ability to generate cash from its operations and maintain financial health.

In addition to the FCF figure itself, investors can examine Apple's FCF trends over time to gain insights into the company's financial stability and growth potential. For instance, a consistently rising FCF may suggest that Apple is effectively managing its resources and operations, leading to increased investor confidence.

However, it's crucial to remember that FCF is just one of the many financial metrics to consider when analyzing a company's overall health and growth potential. Investors should also consider other financial ratios, industry trends, and economic factors when making investment decisions.