Free cash flow

Free cash flow is the cash a business generates from operating, minus what it must spend on physical assets to keep operating.

Why it differs from profit

Net income is calculated under accounting rules that deliberately do not follow cash. Revenue is recognised when earned, not when collected. Large purchases are spread over years as depreciation rather than expensed when paid. Both choices make earnings a better measure of economic activity — and a worse measure of liquidity.

• A company can report a profit while running out of cash, if customers are slow to pay.
• A company can report a loss while generating cash, if large non-cash depreciation charges dominate.
• Earnings involve judgement at many points. Cash movements involve considerably less.

What free cash flow enables

Cash that is genuinely free can do four things, and watching which one a company chooses tells you a lot about management:

1. Pay dividends.
2. Buy back shares.
3. Pay down debt.
4. Fund acquisitions or expansion beyond maintenance needs.

The traps

• Capital expenditure can be deferred. Cutting maintenance spending boosts free cash flow this year and damages the business later.
• Working capital swings distort single quarters. Collecting receivables faster flatters one period at the expense of the next.
• Definitions vary. Some companies present 'adjusted free cash flow' with items removed. Read the reconciliation.
• Share-based compensation is a real cost that does not consume cash. Free cash flow flatters companies that pay heavily in stock.