Free Cash FlowAnalyzing Firms
Cash flow from Operations contains a major problem: It does not display the cash that a company can use freely to improve its business. This role is handled by Free Cash Flow. While a large portion of Cash Flow from Operations is absorbed by maintaining and expanding the long-term assets of the company, Free Cash Flow does not have to be used to increase or expand those assets. This gives firms flexibility since they can use their excess cash flow to finance activities, instead of acquiring capital from external parties in the markets. Firms without free cash flow must either sell shares or borrow capital from the capital markets. You should seek out firms that have large amounts of free cash flow, especially if free cash flow equates to 5% to 10% of sales for the firm.
Free Cash Flow is especially useful when combined with Return on Equity. You can easily determine if the firm is high or low risk by measuring these metrics in relation to each other. A high return on equity, combined with a high free cash flow, is best for a firm. This indicates that the firm is engaged in high return activities and uses fiscal prudence, generating cash that isn’t tied up in obligations. This allows them to continue to fuel and expand their high returns, which feeds them more free cash flow and offers them financial security.
A low return on equity combined with a low (or negative) free cash flow is worst. This indicates that not only is a firm’s cash flow tied up in assets, those assets are generating a low return, slowing the firm’s growth and potentially forcing them to rely on external funding from other sources.
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International Economic Analysis:
- Major Currency Economic Summaries
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