How do you assess the quality and sustainability of free cash flow generation? (2024)

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Cash Management

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FCF calculation

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Valuation models

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FCF quality and sustainability

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Here’s what else to consider

Free cash flow (FCF) is a key metric for evaluating the financial performance and value of a company. It represents the amount of cash that a company generates after deducting the capital expenditures required to maintain or expand its operations. FCF can be used to assess the quality and sustainability of a company's cash flow generation, as well as its ability to fund growth, pay dividends, or reduce debt. In this article, we will explain how to calculate FCF, how to use different valuation models based on FCF, and what factors can affect the reliability of FCF estimates.

1 FCF calculation

The simplest way to calculate FCF is to subtract capital expenditures (CAPEX) from operating cash flow (OCF). OCF is the cash generated from the core business activities of a company, such as selling goods or services, paying suppliers, or collecting receivables. CAPEX is the cash spent on acquiring or upgrading long-term assets, such as property, plant, or equipment. FCF = OCF - CAPEX. However, this formula may not capture some nuances of FCF, such as changes in working capital, non-cash items, or non-recurring expenses. Therefore, some analysts prefer to use alternative formulas, such as FCF = EBIT(1 - tax rate) + depreciation - CAPEX - change in working capital, or FCF = net income + depreciation - CAPEX - change in working capital.

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Free cash flow (FCF) is an important financial metric that measures the amount of cash available for a company to invest in growth opportunities, pay dividends, or reduce debt. While the simplest way to calculate FCF is to subtract capital expenditures (CAPEX) from operating cash flow (OCF), this formula may not account for all relevant factors. Some analysts prefer to use alternative formulas that incorporate changes in working capital, non-cash items, or non-recurring expenses. Ultimately, the choice of formula depends on the nature and goals of the analysis, as well as the availability and quality of the financial data.
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Karim Farah Accounts payable Team lead at CMA CGM
Assessing the quality and sustainability of free cash flow involves examining factors such as operating cash flow, capital expenditures, and working capital changes. Look for consistent positive free cash flow, a healthy operating cash flow-to-net income ratio, and prudent capital expenditure management. Additionally, analyze industry trends, competitive positioning, and any potential risks that could impact future cash flow generation. Regularly reviewing financial statements and management discussions can provide insights into the company's financial health and its ability to sustain free cash flow over time.
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2 Valuation models

One of the main applications of FCF is to estimate the intrinsic value of a company, or the present value of its future cash flows. There are different valuation models that use FCF as an input, such as the discounted cash flow (DCF) model, the free cash flow to equity (FCFE) model, or the free cash flow to firm (FCFF) model. The DCF model discounts the expected FCF by a weighted average cost of capital (WACC), which reflects the cost of both equity and debt financing. The FCFE model discounts the expected FCF available to equity holders by the cost of equity, which reflects the risk and return of investing in the company's shares. The FCFF model discounts the expected FCF available to all stakeholders by the WACC, and then subtracts the value of debt to obtain the value of equity.

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FCF is calculated by subtracting CAPEX from OCF. Alternative formulas may be used to account for changes in working capital or non-cash items. FCF can be used in various valuation models, such as DCF, FCFE, or FCFF, to estimate the intrinsic value of a company. The choice of model depends on the type of cash flow, the perspective of the investor, and the cost of capital.
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3 FCF quality and sustainability

While FCF can provide useful insights into a company's value and performance, it is not a perfect measure. FCF can be affected by various factors that may distort its quality and sustainability, such as accounting choices, business cycles, growth opportunities, or capital structure. For example, a company may report high FCF by deferring CAPEX, inflating OCF with non-cash items, or using aggressive depreciation methods. However, these practices may impair the long-term viability of the company and reduce its future FCF. Therefore, analysts should examine the underlying drivers and assumptions of FCF, and compare it with other metrics, such as earnings, sales, margins, or return on invested capital (ROIC).

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1- Trend Analysis: Look for consistent FCF over time, avoiding short-term spikes.2- Core Operations: Ensure FCF arises from primary business activities.3- Efficient Cost Management: Distinguish between healthy cost-saving and detrimental underinvestment.4- Capital Expenditure: Check if adequate reinvestment supports future growth.5- Debt Obligations: Analyze if FCF is sufficient to cover debt without strain.6-Industry Benchmarking: Compare FCF performance with industry peers.7- Economic Adaptability: Assess FCF resilience under varying economic conditions.
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FCF is a useful metric, but not without flaws. Accounting choices, business cycles, growth opportunities, or capital structure can distort FCF quality and sustainability. Companies may report high FCF through deferring CAPEX or inflating OCF with non-cash items, but these practices may hurt the long-term prospects of the company. To overcome these issues, analysts should scrutinize the drivers and assumptions of FCF and compare it with other metrics like earnings, sales, margins, or ROIC.
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4 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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One way to assess the quality and sustainability of free cash flow generation is to analyze its components, such as operating cash flow, capital expenditures, and changes in working capital. This helps to identify any distortions or abnormalities in the cash flow statement, such as one-time gains, deferred expenses, or volatile inventory levels. Another way is to compare the free cash flow with other financial ratios, such as return on equity, debt-to-equity, or interest coverage, to see if the company has sufficient resources to fund its growth and debt obligations.
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How do you assess the quality and sustainability of free cash flow generation? (2024)

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1 FCF calculation

2 Valuation models

3 FCF quality and sustainability

4 Here’s what else to consider

Cash Management

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