When evaluating a company’s financial performance, investors often turn to two primary metrics: free cash flow (FCF) and net profit. Although both are crucial for analysing a company’s fundamentals, they each provide a distinct perspective. Grasping the differences between FCF and profit can equip investors with a deeper understanding for making more informed decisions.
Net profit
Net profit (or net income) reflects the company’s earnings after all expenses, taxes, and costs have been subtracted from total revenue. It is a vital metric for understanding a company’s profitability over a specific period. A higher net profit is often viewed as a positive indicator, suggesting that a company generates more revenue than it is spending. This can signal efficient operations, healthy margins, and the potential for growth or shareholder returns.
Free cash flow
On the other hand, free cash flow represents the cash a company generates after accounting for the capital expenditures essential to maintaining or expanding its asset base. Essentially, FCF is the cash available to the company that could be used for various purposes, such as paying dividends, repurchasing shares, reducing debt, or pursuing growth initiatives like acquisitions. FCF present a clear picture of a company’s ability to generate actual spendable cash and sustain its operations over time.
The way I like to calculate FCF involves taking the operating cash flow and subtracting maintenance capital expenditures. For example, if a manufacturing company generates $500 million in operating cash flow but needs $100 million to maintain its existing equipment and facilities, its FCF would be $400 million. This FCF figure provides valuable insights into the company’s liquidity position and financial flexibility to invest in future growth opportunities without relying on external financing.
The importance of FCF in business operations cannot be overstated. Companies with healthy free cash flows are better equipped to weather economic downturns, as they have the ability to generate cash to manage short-term obligations. High levels of FCF also give businesses the flexibility to make decisions quickly, whether investing in innovation or enhancing shareholder value through buybacks or dividends.
Comparing free cash flow vs net profit
Net profit often doesn’t tell the whole story, as it can be influenced by accounting practices, non-cash items like depreciation and amortization, and other factors that may distort the true earnings figure. The timing of expenses and various accounting treatments can impact the profit number, which may not accurately represent the actual cash generated by the business.
On the other hand, free cash flow measures the real cash generated by the business operations available for distribution among all shareholders after accounting for the capital expenditures needed to maintain its operational base. By focusing on the cash that is truly available to the firm, free cash flow provides a more accurate assessment of the company’s financial health and ability to fund operations, invest in future growth, pay down debt, or return capital to shareholders.
Therefore, free cash flow is sometimes considered a ‘better’ metric than profit, as it looks beyond just profitability and provides insights into underlying issues such as capital allocation inefficiencies, underreported expenses, or other factors that could threaten the long-term sustainability of the business. While profit remains an important indicator of a company’s earning power, free cash flow offers a more comprehensive view of its financial performance and cash-generating capabilities.
Free cash flow limitations
While free cash flow is often touted as a superior metric for profit, it is not without limitations. One main criticism about free cash flow is the challenge of accurately calculating and interpreting the figure, given the complexity of a company’s capital expenditures.
Often, companies do not clearly break down their capital expenditures into maintenance and growth components. As a result, when using the conventional free cash flow calculation method of subtracting total capital expenditures from cash flow from operations, the free cash flow figure can appear lumpy and distorted, especially for high-growth companies that are heavily investing in expanding their asset base.
To overcome this issue, some analysts prefer to use cash flow from operations as it can also provide a more stable and representative view of the company’s underlying cash-generating ability. For example, a company like Amazon tends to have a lumpy free cash flow figure due to its constant investment in new facilities. In contrast, its operating cash flow remains relatively stable.
The fifth perspective
FCF and net profit are essential metrics for investors, each providing distinct insights and serving unique analytical purposes.
FCF offers a clear view of a company’s financial health by highlighting its ability to generate and retain cash, which is vital for assessing long-term sustainability and investment potential. At the same time, net profit measures a company’s overall financial performance over a specific period. This figure is essential for analyzing profitability trends, evaluating operational efficiency, and comparing the company’s performance to industry peers.
Investors should aim to incorporate both FCF and net profit into their investment process to gain a more comprehensive and nuanced understanding of a company’s financial performance, operational success, and long-term sustainability. By considering the complementary insights provided by these two key metrics, investors can make more informed and well-rounded decisions.
