How to Use Financial Reports to Calculate Free Cash Flow
The first step in determining a company’s solvency is to use financial reports to find out it’s free cash flow or how much money the company earns from its operations that it can actually put into a savings account for future use — in other words, a company’s discretionary cash. This money is also called the free cash flow.
A business with significant cash flow has a lot of flexibility to decide whether it wants to use its discretionary cash to purchase additional investments, pay down more debt, or add to its liquidity, which means to deposit additional funds in cash and cash equivalent accounts (including checking accounts, savings accounts, and other holdings the company can convert to cash). The formula for calculating the free cash flow is simple:
Cash provided by operating activities ˗Capital expenditures ˗Cash dividends = Free cash flow
Cash flows from operating activities are located at the bottom of the operating activities section of the statement of cash flows. Capital expenditures appear in the investing activities section of the cash flow statement. Cash dividends paid show up in the financing activities section of the statement of cash flows.
Using Mattel’s 2007 and 2006 cash flow statements, this is how to calculate the free cash flow in thousands:
|Cash provided by operating activities||$1,275,650||$664,693|
|Minus capital expenditures|
|Purchases of tools, dies, and molds||$108,070||$102,193|
|Purchases of other property, plant, and equipment||$110,978||$88,721|
|Minus cash dividends||$423,378||$4316,503|
|Free cash flow||$633,224||$790,282|
As you can see, Mattel’s free cash flow increased significantly from 2011 to 2012, by a total of about $476 million. Mattel’s cash flow provided by operating activities almost doubled in that time period, from $665 million to $1,276 million.
Clearly, Mattel is recovering strongly after its bout with toxic products from China in 2007. But if you find that a company is having trouble maintaining its previous cash levels, that issue may or may not be a sign of trouble. It may mean that the company decided to maintain lower cash levels and invest in new opportunities, or it may mean that it’s having difficulty generating new cash.
You can’t determine that with this calculation — it tells you that the company may have a problem, but it doesn’t tell you just what the problem may be. The formula merely tells you that you must seek additional information by continuing the financial analysis of other line items (such as Accounts receivable and Inventory) and by reading the notes to the financial statements or management’s discussion and analysis.
Following is how to calculate the free cash flow by using Hasbro’s 2007 and 2006 cash flow statements, in thousands:
|Cash provided by operating activities||$534,796||$396,069|
|Minus capital expenditures|
|Purchases of property, plant, and equipment||$112,091||$99,402|
|Minus cash dividends||$225,464||$154,028|
|Free cash flow||$197,241||$142,639|
Hasbro’s free cash flow shows some improvement from 2011 to 2012, but not as significant as Mattel’s. The increase from 2011 to 2012 is just $54.6 million so Hasbro has no trouble maintaining its cash flow levels — it’s actually improving its cash flow.
What do the numbers mean?
Unquestionably, the more free cash flow a company has, the better it’s doing financially. A company with significant free cash flow is in a strong position to weather a financial storm, whether it’s a recession, a slowdown in sales, or another type of financial emergency.
If a company’s free cash flow number is negative, it must seek external financing to fund its growth. Negative or very low free cash flow numbers for young growth companies that need to make significant investments in new property, plant, or equipment most likely do not indicate a big problem.
But you still want to look deeper into the financial reports, especially the notes to the financial statements, to find out why the cash flow is so low and how the managers plan to raise additional capital. This caveat is especially true if you see a negative free cash flow for an older company, which immediately raises a red flag.