Ideally, a company should not only cover the costs of producing its goods and services, but also actually produce excess cash flow for its shareholders. Cash flows from operations represents a good starting point for this type of analysis. However, beyond current production, a growing company must reinvest its cash to maintain its operations and expand. While management may neglect capital expenditures in the short term, there are fundamental negative long-term growth implications to such neglect. Free cash flow refines the cash flow from operations measure by subtracting capital expenditures and dividend payments from operating cash flow. While you can argue that dividend payments are not required, they are expected by shareholders and they are paid in cash, so they must be subtracted from cash flow to calculate a free cash flow figure.
This free cash flow figure is considered to be excess cash flow that the company can use as it deems most beneficial. With strong free cash flow, debt can be retired, new products can be developed, stock can be repurchased, and dividend payments can be increased. Excess cash flow also makes a company a more attractive takeover target.
You may need to make adjustments to the free cash flow figure depending upon the company's industry. Financials do not typically have large expenditures in brick and mortar property, plant, and equipment expenditures. However, they make significant investments in marketable securities, which are not considered in the standard free cash flow calculation. When looking at the cash flow of a financial firm, it would be best to examine total cash flow figures from the statement of cash flows.
Cyclical firms and companies with long development and construction cycles may have periods of slow sales, inventory build-up, and strong capital expenditures that occur over the normal course of business. A firm such as Boeing, which has a long development cycle for new planes, a long ramp-up period when starting production, and an extended and expensive product construction cycle, may show negative free cash flow until it starts to deliver its planes in quantity.
Conclusion
A firm's cash flows are driven by its sales growth and management's ability to manage expenses, capital investment, and financing in response to that growth. The cash flow statement can give valuable insight into how well a company is managing its growth. Sales, inventory control, production and employee costs, accounts receivable management, interest payment levels, product development, and capital expenditures are some of the elements that impact the cash flow statement. It is critical to understand industry norms to gain a complete understanding of the numbers. Ultimately, firms have to produce cash to do well in the long run.
