Free Cash Flow: A Complete Guide to Understanding FCF

The current article explains the concept of Free Cash Flow (FCF) as responses to the queries asked by readers. This article attempts to discuss various aspects related to Free Cash Flow (FCF) and its usage in company analysis like:

Free cash flow vs net cash generation: which one ascertains the fundamental surplus cash generation ability of a company.
Why do companies with negative free cash flow pay dividends out of debt?
Why would a company with positive free cash flow have high debt?
Why would a company with positive free cash flow not repay debt and become debt free?
Free cash flow vs owner’s earnings
Should a company have equal FCF and CFO?
Applicability of free cash flow (FCF) and self-sustainable growth rate (SSGR) metrics to banks/NBFC/financial institutions

Free Cash Flow (FCF)

FCF vs net cash addition

Hello Dr Vijay,

In our analyses we have always stressed on a positive FCF over the years as a good health indicator for a company. However, we consider only CFO and capex for the calculations. Why is our cash-health analysis complete with the above two factors alone? Shouldn’t nets of CFO, CFI and CFF all be taken into consideration?
If there is a considerable difference between cumulative capex and CFI, why do we consider capex and not CFI?
What is the actual cash available (not necessarily liquid) to the company? Is it cumulative net cash flow or cumulative FCF?
In the below example of Hind Zinc, the FCF is around 30K CR, the Net cash flow cumulative is 7 CR. What is the significance of this difference? The company still took a debt of around 8K CR in spite of having an FCF of 30K CR. May you please help in understanding this scenario?

Here’s an example of Hindustan Zinc Limited (HZL):

Whereas the net cash flow represents a very different picture:

Even by only considering CFI with CFO, net CFI is 27k cr whereas capex is 15k cr.

Thank You in Advance!

Best Regards,

Shreyas

Author’s Response

Hi Shreyas,

Thanks for writing to us! We are happy to see that you are doing your own equity analysis and spending time and effort to understand different concepts. Let us attempt to answer your queries one by one:

1. In our analyses we have always stressed on a positive FCF over the years as a good health indicator for a company. However, we consider only CFO and capex for the calculations. Why is our cash-health analysis complete with the above two factors alone? Shouldn’t nets of CFO, CFI and CFF all be taken into consideration?

A calculation of free cash flow (FCF) by using cash flow from operations (CFO) and capital expenditure (capex) i.e. FCF = CFO – Capex, is helpful in assessing the ability of the business to produce surplus discretionary cash for its stakeholders. FCF is the net cash generated by any business after meeting all the capital expenditure requirements. It means that the capex, which is deducted from CFO includes the maintenance expenses, which is needed to run its existing manufacturing plants smoothly (i.e. maintenance capex) and also the growth capex, which is needed to create new manufacturing plants to achieve future growth.

Therefore, Free Cash Flow (FCF) analysis (= CFO – Capex) intimates an investor whether a company is able to generate discretionary surplus cash or not. FCF is the extra cash, which a company may use for activities like acquisitions of other companies, investment in fixed deposits (FDs) or mutual funds (MFs), repay existing loans, pay dividends or buyback shares from its shareholders. An investor would note that a company will find it difficult to do all these above-mentioned activities in case it is not generating free cash flow (FCF).

Further an investor would also notice that the above mentioned usages of surplus cash (FCF) are shown in the financial statements of any company under either cash flow from investing (CFI) or cash flow from financing (CFF). For example, cash used in acquisitions of other companies, investment in fixed deposits (FDs) or mutual funds (MFs) etc. is shown under CFI whereas the cash used in repayment of existing loans, payment of dividends or buyback of shares is shown under CFF.

We believe that if an investor focuses on net cash generated after CFI and CFF i.e. (CFO +/- CFI +/- CFF) instead of free cash flow (FCF = CFO – Capex), then she would not be able to assess the real surplus cash generating ability of the business. This is because, even in the cases of companies with high FCF, the surplus cash of the company would already have been utilized/invested in FD, MF (CFI) etc. or in dividends, buybacks (CFF) etc. and no significant amount of net cash would have left in hand. Therefore, if an investor focuses only on net cash after CFI and CFF, then she may erroneously conclude that this company is not able to generate any cash.

We can understand it further by taking example of any common household where some of the members earn salaries and use it to spend for different expenses like household expenses, children education etc. Every month, the surplus cash remaining after meeting the expenses is invested in assets like FDs, MFs, PPF and Stocks etc. and some amount of money would be kept at home to meet small cash expenses.

In cash of such a household, the free cash flow (FCF) would be equal to surplus cash left from salary after meeting expenses. Whereas, the net cash generated would be the cash kept at house after investing money in FDs, MFs, PPF, Stocks etc. We believe that to assess the true surplus cash generating ability of this household, an investor would need to focus on FCF (i.e. salary – expenses). If she focuses on net cash after its investments, then she might erroneously conclude that the household is not saving any money, which is not the case.

When we extend the same argument to companies, then we find that the FCF of any company (=CFO – Capex) is the key parameter to ascertain the surplus cash generating ability of the business. The net cash generated after CFI and CFF is the residual value left after a company has used it FCF in the manner it deemed fit like investing in FD, MF, subsidiaries etc. or repayment of loans, dividends, share buybacks etc.

Therefore, in order to ascertain the fundamental strength in the cash flow of any company, we prioritize CFO as the one of the key parameter.

Advised reading: Key Parameters in Assessing Margin of Safety in a Stock

2. If there is a considerable difference between cumulative capex and CFI, why do we consider capex and not CFI?

As mentioned above, the cashflow from investing (CFI) would represent capex as well as other utilizations of the FCF like investments in FDs, MFs, Stocks, acquisitions etc. Therefore, if we deduct entire CFI from CFO to assess surplus/free cash generation, then we might make errors in calculating the fundamental strength of the company. Therefore, we believe that investors should make case to case decision by looking at each of the items of the CFI.

3. What is the actual cash available (not necessarily liquid) to the company? Is it cumulative net cash flow or cumulative FCF?

As mentioned above, the actual cash available from the business to the company, which it can use for other activities like investments (FD, MF etc.), repayment of loans, dividends, buybacks etc. is the free cash flow (FCF = CFO – Capex).

4. In the below example of Hind Zinc, the FCF is around 30K CR, the Net cash flow cumulative is 7 CR. What is the significance of this difference? The company still took a debt of around 8K CR in spite of having an FCF of 30K CR. May you please help in understanding this scenario? Here’s an example of Hind. Zinc where the net cash flow represents a very different picture. Even by only considering CFI with CFO, net CFI is 27k cr whereas capex is 15k cr.

We believe that whenever an investor comes across questions upon looking at the financial data, then the first source to look for answers should be the annual report. This is because most of the times, the annual report contains details of the decisions and the steps taken the management during the year, which provide explanation/answers to investors’ queries. Reading annual report is an essential exercise because the financial numbers in excel cannot provide descriptive information about the company, where the annual report becomes helpful.

In case of Hindustan Zinc Ltd (HZL), if an investor reads the annual report for FY2017, page 69, then she gets to know that the company has paid out about ₹15,000 cr as dividend to shareholders.

Therefore, combining the learning from the excel data and the annual report, an investor would note that in FY2017, Hindustan Zinc Ltd (HZL) generated a CFO of about ₹7,500 cr., did a capex of ₹2,000 cr resulting in a free cash flow (FCF) of about ₹5,500 cr. As the company paid out dividend of about ₹15,000 cr, therefore, it used debt to raise money to meet this large dividend payout. As a result, investors would notice that the debt of HZL in FY2017, increased from “nil” at the start of the year to about ₹8,000 at the end of the year.

Therefore, we believe that investors should always combine their learning from the financial data in excel with the learning from reading of annual report. Upon the combined assessment of excel and the annual report, the investor would be able to get the answers to most of her queries.

Advised reading: Understanding Annual Report of a Company

An investor may also note that in case of the data provided by Screener through the export to excel feature, for many companies, the financial data of last 2-3 years does not include the data of dividend payouts. Therefore, reading the annual reports becomes quintessential for getting a complete picture of fundamental business of companies.

Hope it answers your queries.

All the best for your investing journey!

Regards,

Dr Vijay Malik

Why do companies with negative free cash flow pay dividends out of debt?

Hi Dr,

I found it interesting to find you, a medical person, so methodical & scrupulous in accounting.

Overall, I have learned some fundamental principles of accounting, reading BS, PL account. Now I am confident of reading annual reports, which earlier I used to shun away as I am from a science background.

I would request you to clarify the following:

In companies with negative free cash flow (FCF), which have taken debt to fund their expansion projects, we assume that the dividends are also funded out of the debt. I wish to know why did that promoter take debt to give out dividends. Is it just to create a rosy picture? In addition, how did bankers or financiers kept on funding? They must be clever than a poor retail investor!

Author’s Response:

Hi,

Thanks for writing to us! We are happy to know that you found the workshop value adding.

One of the reasons for promoters to give dividends despite poor operating cash flows can be that they would be the largest beneficiary of such payments considering that promoters are the largest shareholders of the company. Bankers might have kept on funding assuming that in future the business cycle will revive and the company might make up for all the interest payments and loan repayments etc.

Further advised reading: Why Management Assessment is the Most Critical Factor in Stock Investing?

All the best for your investing journey!

Regards,

Dr Vijay Malik

Why would a company with positive free cash flow have high debt?

Hi Dr. Vijay,

I have recently discovered your website and cannot put into words how much I am learning every day by simply reading your various blogs/articles.

Recently I started reading about the Margin of Safety/FCF/SSGR concepts you have written about which make so much sense.

Read: 3 Simple Ways to Find Out Margin of Safety in a Stock

I have a couple of doubts after reading these articles that I have not been able to fully figure out on my own. Hence requesting if you could kindly help throw some more light on it.

Self-sustainable growth rate (SSGR) looks at obviously the ability of the company to grow its business in terms of topline and hence probably differs from other profitability metrics like RoE which focus almost always on bottom line. Why do you focus on the top line? Esp. when topline can be influenced by many exogenous factors, like say, in the case of companies which use crude derivatives (e.g. Aarti Industries). In such cases looking at top line growth may not give the correct picture I think. Can you please comment on this?
Does looking at free cash flow (FCF) alone give you the full picture of whether the company will need to resort to debt in order to grow? For example, I have found a number of cases, where despite FCF being +ve over 10 yrs, the debt has grown significantly. What are the reasons this can actually happen?

I found that one reason could be that the company is borrowing money to pay interest and dividends etc. and it gets into a loop: take new debt to pay off old debt. One example again I can quote is of Aarti industries. Can you please comment on this as well?

Thank you so much in advance.

Warm regards,

Author’s Response:

Hi,

Thanks for your feedback! We are happy that you found the articles useful!

SSGR provides an output as the top line growth but it has NPM has a constituent parameter (referring to the formula):

SSGR = NFAT*NPM*(1-DPR) – Dep

SSGR effectively tells an investor the sustainable growth rate assuming constant NPM i.e. PAT is also expected to improve in line with sales growth. If the NPM improves/declines for the company, the SSGR will improve/decline as well.

FCF positive companies having high debt is something, which should always be explored further. It might be that money is being diverted from the company as loans & advances to other companies, unaffordable dividends etc.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Why would a company with positive free cash flow not repay debt and become debt free?

Sir,

I have come to a scenario where SSGR is 8-9% and 10 Yr sales growth is 13%…it looks like less MoS but at the same time company have CFO 572 cr of 10 Yr and 10 Yr capex is 361cr so FCF of 212cr of 10 yr. the company paid 42 cr in dividend but at the same time, the debt level has increased in 10 Yrs from 112 cr to 208cr. but D/E is 0.5, so I am confused here at p/e13, d/e 0.5 and SSGR < sales growth and having positive FCF and FCF to CFO is 37%, do this company have any MoS?

Read: Finding Self Sustainable Growth Rate (SSGR): a measure of Inherent Growth Potential ofa Company

One more thing if the company have FCF of 211cr as FCF, then why it is not paying entire debt and become debt free and 1 or 2 Yr no need to give a dividend. Anyway, I try to find this answer in AR but I would like your view on the same.

The company name is: Mirza international

Author’s Response:

Hi,

Thanks for writing to us.

Mirza international has already been analysed on the blog in response to a reader’s query. You may read it here:

Read: Analysis: Mirza International Limited (Red Tape Shoes)

FCF does not factor in interest payments as interest payment is part of cash flow from financing. The total P&L interest expense of Mirza International for 2007-16 is Rs. 237cr. which leaves little money for debt reduction. Instead, the FCF being Rs. 212 cr. is not sufficient to meet the interest expense and the company has to take additional debt (Rs. 93 cr.) in last 10 years to service the interest and pay dividends.

Hope it answers your concerns.

All the best for your investing journey!

Regards

Free Cash Flow vs Owners’ Earnings

Hello Dr. Vijay,

I have gone through some blogs where I come to know about owner’s earning and I got confused between FCF and Owner’s earning. As per your template FCF = CFO – capex where capex contains (NFA+WIP changes + DEP). Whereas Owner’s earning looks same except capex contains only maintenance capex and not growth capex. Can we assume Maintenance capex = Depreciation and Amortization and growth capex=NFA+ WIP changes? Could you please throw some light on Both Owner’s earning and FCF? And why we are focusing on FCF in the template and not on Owner’s earning.

Regards

Author’s Response:

Hi,

Thanks for writing to me!

There are many parameters, which find relevance in investment evaluation. FCF, owner’s earnings and many other such parameters can be such examples. Every investor chooses the parameters, which she finds relevant to her in terms of understanding, availability of data, ease of computation, relevance in industry, relevance in particular market and many other such influencing factors.

Moreover, finance provides the freedom to the investor to tweak the formula/calculation of ratios/parameters as per her preference. E.g. ROCE may be calculated by PAT/CE or PAT/total assets or PBT/Total assets. Thereby, each ratio can be calculated and interpreted by the investors on their own.

We as investors have not delved into owners’ earnings, which other investors might have found useful. We believe that FCF calculation with a deduction of total capex serves our purpose well and therefore FCF is being used. As with incremental learning over time, we might tweak the parameters currently being used by us in future to reflect new learnings.

Read: 3 Simple Ways to Find Out Margin of Safety in a Stock

There are many parameters for stock analysis and we advise that the investor should choose, which parameters serve them best and limit the analysis to selected parameters to make the stock analysis concise and meaningful as expanding the analysis beyond a particular expense hampers the decision-making.

Therefore, due to the factors mentioned above, we do not use owners’ earnings as FCF is serving the purpose well for us. However, this is not to say that other investors who find owners’ earnings useful are wrong or should not use it. It is just to state that we have not felt the need to use owner’s earnings, therefore, it has been out of our checklist.

Read: Final Checklist for Stocks Analysis

Hope it answers your concerns.

All the best for your investing journey!

Regards

Should a company have equal FCF and CFO?

Dear Dr Malik,

Appreciate your thoughts.

I have picked from one of your articles, mentioned by you saying, “One should rely more on FCF than CFO while analyzing cash flow statement.”

As you have explained FCF = CFO – Capex, this helps us to mitigate the risk of companies trying to inflate earnings and CFO by capitalizing day-to-day operating expenses.

My understanding is to avoid the inflated earnings and CFO risk, so why do we not compare cPAT with cFCF.

Looking forward to your invaluable insight.

Kind Regards

Author’s Response:

Hi,

Thanks for writing to us!

We believe that the logic of using CFO-capex (i.e. FCF) to compare with PAT is correct in its limited context that it will provide adjustment in case management is capitalizing day-to-day operational expenses. However, as capex also includes genuine capital expenditure in plant and machinery, therefore, deducting entire capex, which might include expenditure on plant and machinery as well as capitalized operating expenditure by the management, if any, will unnecessarily penalize the company.

To have an analogy: PAT is like CTC of an employee, CFO is like take-home salary and FCF is the savings of the household after meeting the expenses. So PAT and CFO might be compared with each other but comparing PAT and FCF and expecting them to be equal may not be a prudent idea.

Further advised reading: 3 Simple Ways to Find Out Margin of Safety in a Stock

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Are the parameters of Free Cash Flow & SSGR applicable to Banks/NBFCs as well?

Dear Vijay,

I had attended your 2nd peaceful investing workshop at Mumbai and this article was a great revision of sorts. However, could you explain how the SSGR as formulated by you and the requirement to have FCF can be used while studying financial institutions like NBFCs?

Does the concept remain same?

Regards

Read: Finding Self Sustainable Growth Rate (SSGR): a measure of Inherent Growth Potential ofa Company

Author’s Response:

Hi,

It was great to have you at the workshop. Being from defence background, you had brought in diversity in the workshop.

SSGR & FCF are highly relevant for companies, which have to rely on assets for generating new business. This is because SSGR relies heavily on the net fixed asset turnover (NFAT) and FCF is a result of capital expenditure (capex). For companies like financial institutions/NBFC/IT companies, which are mainly service industries and new business does not depend a lot on the amount of fixed assets, SSGR & FCF do not retain same importance.

Read: 3 Simple Ways to Find Out Margin of Safety in a Stock

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

P.S.

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We have used the financial data provided by screener.in and the annual reports of the companies mentioned above while conducting analysis for this article.