What is Free Cash Flow?
Free cash flow (FCF) is a financial metric representing the amount of cash a company has available after deducting its operating expenses, taxes, and investments in fixed assets. It measures the cash generated by the company’s operations for various purposes, such as investing in new projects, paying down debt, issuing dividends to shareholders, or retaining funds for future growth.
The formula to calculate free cash flow is as follows.
Free Cash Flow = Operating Cash Flow – Capital Expenditures
A positive free cash flow indicates that the company has generated more cash than it has invested in fixed assets and is in a favourable position to pursue growth opportunities. In contrast, negative free cash flow suggests that the company has invested more in fixed assets than it has generated in cash from its operations, which may require external financing or a reassessment of its investment strategy.
What is Free Cash Flow Conversion?
Free Cash Flow Conversion provides insights into how effectively a company converts its operating cash flow into free cash flow. As discussed, free cash flow represents the cash a company has available after deducting its operating expenses and capital expenditures. Free cash flow conversion helps examine the proportion of operating cash flow that converts into free cash flow.
It helps evaluate how efficiently a company utilizes its operating cash flow to generate surplus cash. A higher free cash flow conversion percentage indicates a better ability to convert operating cash flow into free cash flow. This metric is crucial because it provides insights into a company’s cash flow efficiency. It also helps assess a company’s financial performance, ability to generate and retain cash, and capacity to allocate capital effectively.
How to calculate Free Cash Flow Conversion?
The formula to calculate free cash flow (FCF) conversion is relatively straightforward. It measures the proportion of a company’s net income converted into free cash flow, which is the cash generated by the business after accounting for operating expenses and capital expenditures. The formula is as follows:
FCF Conversion = (Free Cash Flow / Net Income) x 100
In this formula, “Free Cash Flow” represents the actual cash generated by the company, and “Net Income” refers to the profit earned by the business after deducting all expenses and taxes. By multiplying the ratio by 100, companies can express the FCF conversion as a percentage, indicating the proportion of net income converted into free cash flow.
A high FCF conversion percentage indicates that a significant portion of the company’s profits gets converted into cash, usually considered favourable. On the other hand, a low FCF conversion percentage may suggest that the company is utilizing its profits less efficiently or has substantial capital expenditures that reduce the cash generated.
Example
Red Co. is a that operates in the retail industry. The company had a net income of $250,000 last year, while its free cash flow was $200,000. Based on this information, the free cash flow conversion for the company will be as follows.
FCF Conversion = (Free Cash Flow / Net Income) x 100
FCF Conversion = ($200,000 / $250,000) x 100
FCF Conversion = 80%
In this example, Red Co. has an FCF Conversion of 80%. It means 80% of its net income gets converted into free cash flow, indicating a relatively efficient conversion rate.
Conclusion
Free cash flow (FCF) represents the cash available for use after removing capital expenditure and operating expenses. Free cash flow conversion shows how efficiently a company converts its net income into FCF. Usually, companies prefer a higher FCF conversion ratio since it indicates the company is more efficient at managing its cash flows.
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