Unlocking the Power of Free Cash Flow: A Key to Business Success

Charlene Rhinehart is a CPA, CFE, chair of an Illinois CPA Society committee, and holds a degree in accounting and finance from DePaul University.

The best things in life truly are free, especially when it comes to cash flow. Savvy investors prioritize companies generating strong free cash flow (FCF), as it reflects a business’s capability to reduce debt, reward shareholders, repurchase stock, and reinvest in growth. However, while FCF serves as a powerful indicator of corporate vitality, it’s essential to recognize its limitations and the potential for financial manipulation.

Understanding Free Cash Flow

Free cash flow measures the actual cash a company has left after covering its operational expenses and capital investments needed for sustaining and expanding the business. Unlike reported earnings, which can be influenced by accounting methods, FCF tracks the real cash movement, providing a clearer picture of financial health.

To calculate FCF, you start with cash flow from operations (CFO) found in the cash flow statement, then subtract capital expenditures (CapEx) required for ongoing business activities:

FCF = Cash Flow from Operations − Capital Expenditures

Alternatively, investors can derive FCF beginning with net income, adding back non-cash expenses like depreciation and amortization, adjusting for changes in working capital (current assets minus current liabilities), and finally subtracting capital expenditures:

FCF = Net Income + Depreciation & Amortization − Changes in Working Capital − Capital Expenditures

Adding back depreciation and amortization might seem counterintuitive since they relate to capital spending, but FCF focuses on cash outflows occurring now rather than historical accounting entries. This nuance helps identify companies investing heavily upfront, which might reduce current earnings but promise future returns.

What Free Cash Flow Reveals

Rising free cash flow often precedes enhanced profitability. Companies with growing FCF—spurred by revenue increases, operational efficiencies, cost control, share buybacks, dividend payouts, or debt reduction—are well-positioned to reward investors over time. Consequently, many view increasing FCF as a sign of undervalued shares set for growth.

Conversely, declining FCF can signal trouble ahead. Without sufficient free cash flow, companies may struggle to sustain profit growth, resort to borrowing more, or worse, face liquidity crises threatening their survival.

Beware the Limitations of Free Cash Flow

While highly informative, free cash flow isn’t foolproof. The absence of standardized rules for calculating FCF leaves room for companies to manipulate figures, especially around what counts as capital expenditures. Investors should be vigilant with firms reporting unusually high FCF, as they might be underreporting essential expenses like R&D.

Additionally, companies can temporarily inflate FCF by delaying payments, tightening collections, or reducing inventories—actions that decrease current liabilities and working capital changes but may not be sustainable in the long term.

Common Free Cash Flow Manipulation Tactics

A subtle but impactful trick involves manipulating accounts receivable. Typically, when revenue is recorded, it increases both net income and accounts receivable, which offsets cash flow from operations, keeping FCF neutral until cash is collected.

However, some companies classify delayed payments as non-current receivables hidden under categories like "other investments." This practice inflates reported revenue and cash from operations without a corresponding increase in current receivables, artificially boosting free cash flow. Such schemes are challenging to detect but can mislead investors.

The Takeaway

There’s no single metric that perfectly captures a company’s financial health. Free cash flow, despite its imperfections, remains a valuable tool when analyzed carefully. By staying aware of its potential pitfalls and scrutinizing company disclosures, investors can leverage FCF as a powerful starting point in evaluating business performance and investment potential.

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