Free cash flow: why it matters more than earnings
Accounting profit can be shaped by accounting choices; cash, much less so. Free cash flow (FCF) is the money a company generates after maintaining and growing its business — the money it can use to pay dividends, buy back shares, reduce debt or acquire other companies. We use a fictional company, Example Corp, with the same figures throughout this series, so you can see how the income statement, balance sheet and cash flow fit together.
- FCF = operating cash flow − capital expenditure (capex).
- A healthy company converts a high, stable share of its profit into cash.
- Rising profit with stagnant FCF is a red flag.
- FCF yield (FCF / market cap) is an alternative to the P/E ratio that is harder to manipulate.
- Sustainable dividends come from FCF, not accounting profit.
From profit to cash
The cash flow statement starts from net income and adjusts for non-cash items. Example Corp, in millions of dollars:
Cash conversion
Dividing FCF by net income shows how much of the profit becomes available cash: 70 / 82.5 = 85%.
- Conversion near or above 100% over time usually signals a quality business and "real" earnings.
- Low conversion for years may reflect a capital-hungry business or unreliable accounting profit.
One low year is not serious if the company is investing to grow. The concern is when it becomes the norm.
Maintenance vs growth capex
Not all capex is equal. Part is maintenance (replacing what wears out) and part is growth (new plants, stores or products). Companies rarely split it, but a useful approximation is to compare capex with depreciation: if they are similar, most of it is maintenance.
At Example Corp, capex (55) barely exceeds depreciation (50): the company mostly invests to stand still.
Free cash flow yield
If Example Corp trades at $9.90 per share, its market cap is $990M and its FCF yield is 70 / 990 = 7.1%. In other words, each year the company generates free cash equal to 7.1% of its market value.
It is like the inverse of the P/E, but using cash. Comparing it with bond yields or other companies helps you spot whether a stock is cheap or expensive. See how to value a stock.
Red flags
- Profit growing for several years with flat or negative FCF.
- Operating cash flow inflated by delaying supplier payments.
- Dividends or buybacks larger than FCF, financed with debt.
- Capex far below depreciation for years: the company may be underinvesting to show more cash.
Frequently asked questions
What is free cash flow?
The money a company generates from its operations after paying for the investments needed to maintain and grow the business.
How is FCF calculated?
Operating cash flow minus capital expenditure. Both appear in the cash flow statement.
Why can FCF be lower than profit?
Because the company invests more than it depreciates, builds inventory or collects more slowly. Not always bad, but understand why.
What is a good FCF yield?
It depends on interest rates and expected growth. Compare it with similar companies and the company's own history.