Free cash-flow is a commonly used term in stock analysis. It is the cash left for investors (both debt and equity investors) after cash-outflows for all expenses (excluding interest) and investments (in capital assets like plant, machinery etc). Some investors confuse free cash-flows with another accounting term, Earnings before interest, taxes, depreciation & amortization (EBITDA). There are several differences between EBITDA and Free Cash-Flows:-
- Unlike EBITDA, free cash-flows exclude non-cash items like depreciation and amortization
- Unlike EBITDA, free cash-flows include tax
- Unlike EBITDA, free cash-flows include investments in fixed assets
- Unlike EBITDA, free cash-flows factor changes in current assets and liabilities
While a lot of importance is usually given to EBITDA from an accounting standpoint, free cash-flows are more important because at the end of the day, a business needs to generate cash to remain a going concern and grow revenues / profits. A company which is not able to generate sufficient free cash flows consistently will not able be to meet its obligations towards debt and equity investors and eventually may face bankruptcy, thereby impacting shareholder returns severely. On the other hand, a company which generates sufficient free cash-flows on consistent basis has a sustainable business model. Fund managers like to invest in companies which have a good track record of generating free cash-flows.
Suggested reading: Importance of free cash flows in equity investing and Operating cash flow and its importance
