Why Free Cash Flow?
In this post, I will discuss the benefits of using Free Cash Flow (FCF) instead of Net Profits to evaluate the worthiness of our potential investments. FCF is simply Net Cash Provided by Operating Activities – Capital Expenditures. Companies with healthy FCF are able to pay dividends, acquire other companies and pay off their debts. Cash is the lifeblood of all companies, and without it, you can be sure that weren’t be around for very long.
I have included figures from the now defunct behemoth, Enron to illustrate my points.
By all means, Enron appeared to be a fantastic company. Revenue had jumped seven-fold and net income had jumped two fold in a short span of five years! Pundits loved the company and the stock priced soared.
Free Cash Flow on the other hand, tells us a vastly different tale:
In four out of five years, the company was facing a massive outflow of cash. A tell-tale sign that something is amiss. Enron had burned through all its cash and still required a substantial amount of money to keep running. Eventually, it was revealed that fraud was being perpetuated. Enron eventually closed its doors as it crumbled beneath its own weight.
If it doubt, always remember the old axiom: Cash, not profit is king!