Free Cash Flow is the most important parameter while shortlisting a company for investment purpose. As the name suggests, it is the excessive cash left with the company after doing capital expenditure.
Free Cash Flow(FCF) = CFO – Capital Expenditure.
CFO = Cash flow from operation (available in Cash Flow Statement)
Capital Expenditure = (NFA+CWIP) at the end of the year – (NFA+CWIP) at the start of the year + Depreciation for the year.
Free cash flow is additional cash that a company is able to generate for its shareholders. It is important to look for a company which has a positive FCF for a long period of time i.e 10 years.
Negative FCF for a few years should not be seen as a worry as the company might have done major capital expenditure on plants and machinery to generate future earning for the company.
But for a longer period of time say 10 years company should have Positive FCF. Negative FCF means that the company is earning less and spending more. Negative FCF leads to company depending on an external source like debt and equity dilution.
Increase in debt will give rise to interest payment which will reduce the net profit of the company, while equity dilution will reduce shareholders value in the company.
In simple term, FCF is the actual cash available to the company which it has generated from doing the business. This cash can be used for doing investments in FD or Mutual Funds, repayment of the loans taken by the company, dividends, buybacks etc.
FCF gives a great insight into the management quality of the company. There might be cases where the FCF of the company is negative and still, the company is paying dividends. It is a clear case of dividends being paid by raising a loan.
The second case might be that the company is having high FCF and high debt also. It can be that the company is into capital-intensive business and profit might be getting exhausted in paying interest expense which will lead to an increase in the debt level of the company.
Free Cash Flow is the best indicator to explain the importance of Cashflow Statement whiling doing the research on any company for investment.