Question

Describe the concept of "free cash flow" and how it provides additional insight into a company's cash generating ability.

Answer 1

Free cash flow :

Free cash flow is the cash balance of a business/company generated after cash outflows to cover operations cost and maintain its capital assets. Unlike earnings or net income, free cash flow measures the profitability of the business that excludes non-cash expenses of the income statement and includes spending on equipment and assets. It also includes the changes in working capital. Interest payments are generally excluded but for finding the expected profitability it sometimes used.

Since Free cash flow accounts for the changes in working capital, it can provide important insights into the value of a company and the trend of a company. For example, a decrease in accounts payable (outflow) could mean that vendors are requiring faster payment. A decrease in accounts receivable (inflow) means the company is collecting from its clients more quickly. An increase in inventory (outflow) could indicate that there is a stockpile of unsold products. Since it includes working capital in a measuring the profitability, it provides an insight that is missing from the income statement.