Free Cash Flows
After a company has finally paid off all the expenses including the investments the amount of cash that is left is known as free cash flow. It may also be known as operating cash flow minus capital expenditures. Free cash flow is actually the net cash that is left after paying off all the expenses.
A company with negative cash flow doesn’t signify that it is bad because new companies usually spend a lot of cash. They do investments getting high rate of return due to which they run out of cash at hand. Since the availability of cash does not appear so attractive to investor, high rate of return and investment is therefore given much more importance. It is also considered a good sign of financial position. Some people believe that free cash flow gives a more genuine reason why an investor should invest in a company. Earnings can be shown with some changes in the accounts or better known as accounting gimmicks. It is never important that if a company is showing negative free cash flow it is in loss or not in a position to pay off returns. In some cases companies invest a lot in high rate of return projects which is a good sign for the investor.
Free cash flow is simply calculated as Cash Flow from Operations minus Capital Expenditures. Free cash flow states the net cash while net income states the profitability of the company. For example net income of a company per year is $1000. Before depreciation the cost of one truck is $1000. Suppose that year besides free cash flow everything came to 0, so net cash flow from operations will be $1000 minus capital expenditure $1000 making cash flow $0 for this year. If the useful life is 4 years, the truck will be depreciated for $250/year making net income per year $750. Since depreciation is added back net cash flow from operations will be $1000 for the next four years. Therefore free cash flow for the next 4 years will remain the same i.e $1000, while capital expenditure will be $0.