What is “free cash flow”?
Photo: Redmark. Source: Wikipedia
Free cash flow is an accounting term that measures how much cash a company can generate from its business after taking out capital expenditures – money spent for new computers or new buildings or new delivery vehicles. It’s the cash that’s left over after you spend what you need to keep the business going and growing. It’s important: it allows companies to pursue new opportunities without relying on the kindness of their bankers, or the bond market.
It’s not the same as earnings. Earnings take into account accruals and amortization and other noncash activity. It’s not the same as cash from operations. That measure doesn’t consider all the non-operating investments companies need to make. For example, after Target was hit by a data breach, they had to make some serious investments in their data security – investments that cost up-front money today, but that they could amortize over time. Those necessary investments reduce free cash flow.
It’s easy to get cynical about custom accounting practices. Companies often add “stuff” into their statements to make them look more positive. WeWork, the shared office startup, recently introduced a new accounting term: “community-adjusted earnings before interest, taxes, depreciation, and amortization.” In this measurement, they subtracted out ordinary business expenses like marketing and design. One article mocked WeWork’s creative accounting with some satirical measures, like EBACE – earnings before all conceivable expenses, or EBWAEA – earnings but what are earnings anyway.
But free cash flow uses standard, audited accounting measures to measure how much extra cash a corporation has available after a year’s business activity. Free cash flow is what’s available on a sustainable basis for dividends, stock repurchases, acquisitions, and new investments. Cash-flow machines, like Apple, Google, and Facebook, need to find new ways to put their cash to work, in ways that can keep their businesses growing.
Free cash flow is important. It measures how much flexibility management has. Whether managers use that cash in an intelligent way, however, is another matter.
Douglas R. Tengdin, CFA
Charter Trust Company
“The Best Trust Company in New England”