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
