Free Cash Flow Explained

From time to time I get a little bit ahead of myself and start talking about things such as Shareholder Yield and I forget that I have yet to explain the factors leading up to increasing shareholder yield such as free cash flow.

What is Free Cash Flow?

Free cash flow is simply a measure of the ability of a company to generate internal growth. This is sometimes referred to as organic growth.

How is Free Cash Flow Calculated?

Free cash flow is calculated by adding net income with depreciation and deferred taxes and then subtracting dividends paid and capital expenditures.

Net Income + Depreciation + Deferred Taxes – Dividends Paid- Capital Expenditures = Free Cash Flow

What Does It All Mean?

If free cash flow is positive then the company has done a good job of managing its cash. If free cash flow is negative then the company may have to look for other sources of funding such as issuing additional shares or debt financing.

If a company has a negative free cash flow and has to issue more equity shares, this will dilute the profits per share. If the company chooses to seek debt financing, there will be additional interest expense as a result and the net income of the company will suffer.

When investing for dividend growth, we can assume that for a company to continuously grow its dividend, there must be positive cash flow.

Free cash flow is one indicator of the ability of a company to return profits to shareholders through debt reduction, increasing dividends, or stock buybacks.

All of these scenarios result in an increased shareholder yield and a better return on your investment.