Cash flow and free cash flow
Operating cash flow shows what the business generates; free cash flow shows what is left after keeping the lights on and growing.
The three sections
Operating activities cover cash from the core business. Investing activities cover capital expenditure and acquisitions. Financing activities cover debt, equity issuance, buybacks, and dividends.
A healthy mature company generates cash from operations, spends some on investing, and returns or reinvests the rest. A company whose cash comes mainly from financing is funding itself with other people's money — sometimes a reasonable growth choice, sometimes a warning.
Free cash flow
Free cash flow is commonly operating cash flow minus capital expenditure. It approximates the cash genuinely available to pay down debt, buy back shares, pay dividends, or bank for opportunities.
Separate maintenance capex from growth capex where disclosure allows. A company whose capex merely maintains existing capacity has a very different profile from one building new plants.
Working capital tells on you
Receivables growing faster than revenue suggests customers are slower to pay, or that revenue was recognised aggressively. Inventory growing faster than sales suggests demand softening. These lines often move before the income statement does.
Worked example
Computing free cash flow and a yield
- Net income $180m; add back depreciation $70m (a non-cash charge).
- Working capital consumed $40m of cash this year, so subtract it.
- Operating cash flow = 180 + 70 - 40 = $210m.
- Capital expenditure was $90m, so free cash flow = 210 - 90 = $120m.
- With a $2.4bn market cap, FCF yield = 120 / 2,400 = 5%.
FCF yield gives a cash-grounded sense of what you receive per dollar invested, and it is harder to dress up than reported earnings.
Common misconceptions
“Depreciation is a cash cost this year.”
It spreads a past cash outlay across years. The current-year cash cost is capex, which is why FCF subtracts capex and adds depreciation back.
“Negative free cash flow is always bad.”
A company investing heavily in genuinely profitable capacity can be creating value. The test is the return on that investment.
Checkpoint