Effects of free cash flow on the profitability of firms

Cash Flow

Free cash flow (FCF) is a critical business performance metric. Free cash flow is the remaining cash after a business pays for all expenditures such as debts, expenses, employees, fixed assets, plant, rent etc.
This cash can be used for paying dividends to investors, developing new business, manufacturing new goods or paying any other financial obligations. FCF is the amount of leftover money in a company. FCF is regarded as a company’s current cash value.

Types of Free Cash Flow:

  1. Free Cash Flow to the Firm (FCFF) also referred to as “unlevered”
  2. Free Cash Flow to Equity also knows as “levered”

Cash flow versus free cash flow
Free cash flow is not the same and is different from cash flow. Cash flows are inflows and outflows of cash, cash equivalents, and other liquid current assets. In a cash flow statement of a business, operating cash flow is the amount of cash generated from its operations over a specific period of time. It is unlike profit or net income, which contains sales or purchases made on credit, and hence it is not physically paid for at the end of the period.

Free cash flow is derived from operating cash flow, less capital expenditure for a specific period. The figures for operating cash flow and capital expenditure are easily collected from cash flow and income statements. The generally approved equation for free cash flow is:

FCF = Cash from Operations – Capital Expenditures

Typically, because of the volatility in free cash flow, it’s best to observe free cash flow over a period of a few years rather than a single year or quarter.

Profitability is basically considered the capability of a business to earn a profit. A profit is what is left of the revenue generates after all expenses directly related to the generation of the revenue are paid. This could be related to producing a product or any other expenses related to the conduct of the business activities.
Profitability, efficiency, solvency, and market prospects are four significant building blocks for analyzing financial statements and company performance as a whole. These vital concepts analyze how well a company is doing and the prospective future it could have if operations were managed accurately.

Revenues and expenses are the two main features of profitability. Revenue is the business income and is the amount of money earned by selling goods or services. However, generating income isn’t free. Businesses must use their resources to manufacture these goods or provide these services.
Resources, like cash, are used to pay for expenses like employee payroll, rent, utilities, and other necessities in the production process. Profitability considers the link between the revenues and expenses to see whether a company is performing soundly and the future prospective growth a company might have.

Effects of free cash flow on the profitability of firms
FCF is a measure of a business’s ability to generate cash. A positive FCF figure indicates that the business has the cash to reduce debt, expand or pay out dividends. If FCF figures are increasing over time, this is a beneficial indicator for investors, showing positive business health. Similarly, if FCF is declining, it could point to trouble ahead. Conversely, a negative free cash flow figure would require a detailed inspection. Negative free cash flow is not always considered harmful, particularly when it is because of the business making investments.
Free cash flow is usually significant from the perspective of investors. However, FCF is also an important figure for business – even for those businesses which are not looking to raise capital by selling equity.

By tracking a company’s free cash flow, a business’s growth and success are measured. Business with consistently positive free cash flow enjoys multiple options regarding the use of surplus money. Free cash flow can be used to expand operations, bring on additional employees or invest in additional assets, and it can be put toward acquisitions or paid out in dividends to shareholders. However, having too much free cash flow could also indicate that a business is not leveraging its assets appropriately as excess funds could be utilized towards expansion.

If the business has negative free cash flow because surplus money is regularly reinvested for growth, then the negative number is a reflection of that growth strategy. A business with negative free cash flow as a result of a cash flow shortage might need to restructure operations or raise capital by taking on additional debt, selling equity or investing private funds.

Businesses can increase free cash flow:

  • By reshuffling debt to lower interest rates and improving repayment terms.
  • By reducing, limiting or delaying capital expenditures.
  • Hiring competent and qualified employees at high levels to improve financial strategy and business operations with management accounting.

Limitations associated with the free cash flow
The company’s net income greatly impacts a company’s free cash flow because it also affects a company’s capability to generate cash from operations. Other activities which are not within the central business operations of a company and from which the company generates income must be analyzed intensely in order to reveal a more applicable FCF value.
The investors must be cautious of a company’s policies that affect their declaration of FCF. Few companies extend the time to settle their debts to maintain cash or, the reverse; limit the time they collect debts due to them. Companies also have various strategies on which assets they declare as capital expenditures, thus affecting the calculation of FCF.

Since the amount for free cash flow is calculated from operating cash flow, which is in turn achieved from net income, it’s vital to consider that any gain or loss that is not part of the central business can affect free cash flow.

For instance, if a company makes a onetime profit from the sale of an asset, this will represent positively in a free cash flow analysis, augmenting the figure in a manner that it displays the company’s cash generating ability stronger than it actually is.

A company could also influence its free cash flow by extending payment to suppliers, which reserves the cash held in the business or by restricting its customers’ regular payment terms towards the end of an accounting period.

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