In this “What Is…?” series, we demystify investing terms for people who are just starting out in the stock market.
Right now, let’s understand more about the term, “free cash flow”.
So, What Is Free Cash Flow?
Free cash flow is the amount of money generated by a business after accounting for operating and capital expenses.
The free cash flow of a company can be then used to reinvest into its own business, acquire other businesses, pay dividends to its shareholders, buy back its own shares, or pay off its borrowings.
Without any free cash flow, the business has to either borrow money from banks or undertake equity fundraising to sustain its daily operations.
As such, free cash flow is said to be the lifeblood of a company.
Free Cash Flow Formula
Free cash flow can be calculated by looking at the cash flow statement of a company’s financial statements.
A simplistic way to derive free cash flow would be to take the “Net cash from operating activities” figure and deducting the “Purchase of property, plant and equipment” figure from the cash flow statement.
Free Cash Flow = Net Cash From Operating Activities – Purchase of Property, Plant and Equipment
The titles may differ from company to company, but they will be worded almost the same.
For example, “Purchase of property, plant and equipment” may be termed as “Acquisition of property, plant and equipment”.
“Purchase of property, plant and equipment” is also known as capital expenditure (capex).
Calculating Free Cash Flow of a Listed Company
To illustrate the free cash flow calculation, let’s take a look at Sheng Siong Group Ltd (SGX: OV8).
For 2019, the company generated S$117.3 million in net cash from operating activities and used S$53.6 million as capital expenditure.
Its free cash flow is, therefore, S$117.3 million minus S$53.6 million, giving us S$63.7 million.
Valuation Figures
From the free cash flow, various ratios can be calculated to compare different businesses in the same industry.
For example, the price-to-free cash flow ratio or free cash flow yield can be calculated to compare between two companies and determine which business is more valuable comparatively.
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Disclaimer: The information provided by Seedly serves as an educational piece and is not intended to be personalised investment advice. Readers should always do their own due diligence and consider their financial goals before investing in any stock.
