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Ratios: Free Cash Flow

Brian Krogol
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Alright now, let's discuss another analysis tool. It's called free cash flow. So I've got it labeled here as a ratio. It's not so much a ratio, but we use it in an analysis in similar ways that we use ratios. So let's go ahead and dive in here. Free cash flow. It measures the cash that was earned from operations. Okay. In general, we're dealing with cash earned from operations here. Okay. So remember we're dealing with cash here. Usually we're dealing with numbers like income, net income, things like that. But now we're talking from a cash perspective. Okay, So when we look at our our formula down here for free cash flow, we're talking about the first thing. Their cash from operating activities. So where do we get cash from operating activities? Well, this is going to come from the statement of cash flows. Right. There's gonna be three sections on the statement of cash flows, cash from operating activities. Cash from investing activities, cash from financing activities. Well, we want to focus on the operating activities. Operating activities, that's like our core business. From doing what we're supposed to do. How much cash are we able to generate from that business? Okay. And this cash from operating activities, like I said, it's the company's cash generating power, you can imagine that's a pretty important number. So we're gonna take that cash from operating activities and we're gonna reduce it for some things. It's for necessary investments in fixed assets. You can imagine. We're gonna have to be buying new machines. We're gonna have to be spending on buildings, whatever it is for our factories, whatever it is, we're gonna be spending money pretty consistently on fixed assets, on long term assets. And we might have necessary dividends that we need to pay to our stockholders to keep them happy. We might have some some dividends that we could consistently pay and we have to keep that up. Right? So that's gonna take away from our free cash flow. Right? So remember, we're focused on cash in this situation. So once we take out these these things like these necessary investments, these necessary dividends were left with the free cash flow. Now in this class, it's not so big of a topic, but I'll tell you when you get to finance, free cash flow is gonna be a huge topic that we talk about all the time. Okay, because in finance, the focus is a lot more on cash rather than on income. Okay, so once you're taking a finance class, you're gonna notice that the focus is always going to be on the cash rather than income. So income is more of an accounting concept, and finance is more focused on that cash. Cool. So here we have the formula, we've talked about it a little bit so far and in this class we're gonna deal with it like this, we're gonna take our cash provided from operating activities. It's usually gonna come from a statement of cash flows. But if you have a multiple choice question, well, they're probably just gonna tell you this amount or have you find it in some little bit of a roundabout way then minus capital expenditures. So capital expenditures, This is money you're spending on fixed assets, Right? So some of that free cash flow, that money that you got from operations, you're gonna have to spend it on the fixed assets and then you might have to pay some dividends as well. So we'll take that out. Okay. For the most part, the free cash flow deals with the first two. But cash dividends are an important part of the calculation as well. So like, like I noted here, sometimes they ignore dividends. So you might want to double check with your professor how they're using the free cash flow formula. They might just have the first two and just not deal with dividends at all. Okay, But we're just gonna add it in there because if in the case that it's zero. If the professor doesn't talk about it, well, it's just zero and you just leave it as zero. So how does this, how do we use free cash flow? Well, remember, this is a focus on cash and cash. Well, remember cash is king, right? Cash is a big deal when it comes to actually making money. So it's the amount of cash generated to expand operations or to pay dividends. Okay, so this free cash flow, right? You could you could bring in cash by taking out a huge bank loan, but that's not sustainable, right? You're gonna have to pay back the loan, you're gonna be paying interest this cash from operating activities. This is sustainable cash generation, right? And that's where we see a lot of the value of the company is being able to generate all this cash flow, all this cash coming in. Well, this is a good thing for investors to focus on now. What if we see a negative free cash flow? This could indicate that the operating cash flows are bad, right? They're not high enough. We can say they're low. So if we have low free cash flows, low operating cash flows, while we might not be able to cover our fixed assets that we need to buy, we might need to take out a loan to buy those fixed assets or we might need to raise, raise money from our stockholders to pay for those fixed assets. It would be much better if we could just pay for those out of our operating cash flows, right? We generate enough cash to buy these things. However, a negative free cash flow might not all be bad. Right? It could also mean that you're investing a lot, there's a lot of investment into fixed assets, right? You might still have some good operating cash flows, but you're expanding your business a lot and you're buying a lot of fixed assets. So you can expand production. Well, this could mean that you're gonna provide a lot of free cash flows in the future, right? You're expanding the business to be able to generate even more cash in the future. So negative free cash flow in the current period might not totally be a bad thing. You want to kind of analyze why it's negative. Is it because the operating cash flows are low? Or is it because you're investing a lot into fixed assets so that you can grow and be even more uh able to generate cash in the future. Okay, So in the end, it's a pretty simple formula, especially when you get it in a multiple choice format. So let's go ahead and do some practice problems. Alright, let's do it now.