Economics Homework Help

Learning Engagement # 4

Topic:

Explain what is free cash flow as opposed to just cash flow? Why is it important to calculate fee cash flow for a company?

PROFESSOR’S GUIDANCE FOR THIS WEEK’S LE:

Not every cash produced by a business is available to its owners. You need to explain why and how? Why free cash flow is an important measure?

Topic:

Free Cash Flow and Cash Flow.

Free Cash Flow:

Free cash flow is the cash generated by a corporation from its normal business activities before interest payments and after capital expenditures are deducted. Purchases of long-term fixed assets, such as property, plant, and equipment, are referred to as capital expenditures, or CAPEX.

Free cash flow is important to investors because it shows how much actual cash a company has at its disposal. Free cash flow is the money left over after a company has met its operating and capital expenditure requirements and it can be the best way to differentiate between a good investment and a bad one (Drury, 2021).

Cash Flow:

The operating cash flow generated by normal business operations or activities, on the other hand, is referred to as cash flow. Operating cash flow indicates whether or not a company generates enough positive cash flow to run its operations and grow.

When comparing competitors in the same or similar industries, free cash flow, and operating cash flow are frequently employed as measurements. When investigating and analyzing a firm for investment, operating cash flow, free cash flow, and earnings are all crucial measures to examine (Drury, 2021).

Why is it important to calculate free cash flow for a company?

Free cash flow is important because it allows a company to pursue opportunities that enhance shareholder value. Without cash, it’s tough to develop new products, make acquisitions, pay dividends and reduce debt. If free cash flow is negative, it could be a sign that a company is making large investments. Cash flow finds out the net cash inflow of operating, investing, and financing activities of the business. Free cash flow is used to find out the present value of the business. The main objective is to find out the actual net cash inflow of the business.

Free cash flow is typically calculated as a company’s operating cash flow before interest payments and after subtracting any capital purchases. Capital expenditures are funds a company uses to buy, upgrade, and maintain physical assets, including property, buildings, or equipment (Drury, 2021).

Operating cash flow is calculated by taking revenue and subtracting operating expenses for the period. Operating cash flow is recorded on a company’s cash flow statement, which is reported both on a quarterly and annual basis. Operating cash flow indicates whether a company can generate enough cash flow to maintain and expand operations, but it can also indicate when a company may need external financing for capital expansion.

When a company needs to service its debts, pay dividends or invest in equipment, it needs cash to do so. If a company has a large amount of excess cash, depending on the industry, it might be able to ramp up production, fuel acquisitions, or return money to shareholders. Also, companies might start booking revenue before the cash has even been paid by its customers. If customers delayed paying it could cause serious issues. The shortfall in cash caused by the company not getting paid on time or in contractual disputes meant there was an increasing shortfall of the cash needed to meet its day-to-day obligations (Stevenson, 2018).

Not every cash produced by a business is available to its owners. You need to explain why?

As a growing business, you are likely to be spending more than you have in profits because the company is investing in long-term assets to fuel its expansion. These purchases typically involve an expenditure of cash. However, the expense won’t be recognized in the same period as the cash outlay.

Cash reserves are vital to companies. The reserve holds money that a business can use when unexpected costs come up or when revenues are down. Calculating company revenue and subtracting expenses gives companies the amount per month they need to cover themselves. That’s why it’s critical to maintain a level of working capital that allows you to make it through those crunch times and continue to operate the business. Simply put, cash flow management means delaying outlays of cash as long as possible while encouraging your customers to pay it as quickly as possible (GrowthForce, 2018).

Not every cash produced by a business is available to its owners. You need to explain how?

Cash flows show the liquidity of a business. Inventory and the cost of goods sold also affect profits, but not necessarily cash because of the timing of the expenses. For example, you may have bought products to put into inventory including products you haven’t yet sold.

Cash is coming in from customers or clients who are buying your products or services. If customers don’t pay at the time of purchase, some of your cash flow is coming from collections of accounts receivable. Cash is the lifeblood of a business, and a business needs to generate enough cash from its activities so that it can meet its expenses and have enough left over to repay investors and grow the business. While a company can manipulate its earnings, its cash flow provides an idea about its real health (Thangavelu, 2021).

Why free cash flow is an important measure?

Free cash flow is an important measurement since it shows how efficient a company is at generating cash. The cash a firm generates after cash outflows to sustain operations and maintain capital assets is referred to as free cash flow (FCF). To put it another way, free cash flow is the money left over after a company’s operational and capital expenses have been paid (CapEx). Investors use free cash flow to measure whether a company might have enough cash for dividends or share buybacks.

FCF is the money left over after paying for things like payroll, rent, and taxes, and it’s up to the business to do whatever it wants with it. A company’s cash management will be aided by knowing how to calculate and analyze free cash flow. Investors will gain insight into a company’s financials as a result of the FCF calculation, which will aid them in making smarter investment decisions (Murphy, 2021).

References.

Drury, A. (2021). Free Cash Flow vs. Operating Cash Flow: What’s the Difference? Corporate Finance & Accounting. Financial Ratios. Investopedia

GrowthForce (2018). Why Profits Don’t Equal Cash Flow. GrowthForce, LLC

Murphy, C. (2021). What Is the Formula for Calculating Free Cash Flow? Corporate Finance & Accounting. Financial Ratios. Investopedia.

Stevenson, D, (2018). What Is Free Cash Flow AndWhy Is It So Important? Sharesmagazine

Thangavelu, P. (2021). Why Cash Management Is Key To Business Success. Business. Business Essentials. Investopedia

(S) A_Plus_Student:

Include

Explain what free cash flow is as opposed to just cash flow? Why is it important to calculate free cash flow for a company?

The financial performance of a corporation is measured by free cash flow (FCF). It depicts the amount of cash a firm may generate after deducting the cost of assets from its operating cash flow, such as real estate, equipment, and other significant investments. In other words, FCF assesses a company’s potential to generate what matters most to investors: cash that may be distributed at any time.

Free Cash Flow Types:

It’s not always clear what someone means when they say FCF. People could be referring to a variety of different measurements.

The following are the most prevalent types:

• FCFF (Free Cash Flow to the Firm), sometimes known as “unlevered” cash flow, is a type of cash flow generated by a business.
• The term “levered” refers to the ratio of free cash flow to equity.

The Importance of Cash Flow:

Management can decide on future endeavors that will increase shareholder value by knowing the company’s free cash flow. Furthermore, having a large FCF suggests that a corporation can pay its monthly obligations. FCF can also be used to grow a company’s operations or make other short-term expenditures.

As opposed to earnings per se, free cash flow is more transparent in demonstrating the company’s ability to generate cash and profits.

Investors may generally make successful investments with companies with significant FCF if they combine this with a low-valued share price. Other entities willing to invest, on the other hand, may favor companies with an excellent free cash flow and a bright future. Other investors value FCF over other metrics because it serves as a critical foundation for stock valuation.

What is the formula for calculating FCF?

There are a few different approaches to calculating FCF, but they should all yield the same answers. The following is a straightforward and widely used formula for calculating levered free cash flow:

Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures (CFI, 2017).

The following are the distinctions between cash flow and free cash flow:

• Free cash flow is a very narrow definition of cash flow. The use of free cash flow is restricted; but, the utility of cash flow is limitless.
• One of the most significant four financial statements in financial accounting is the cash flow statement. The cash flow statement, on the other hand, is used to compute free cash flow.
• The cash flow statement is used to determine more than just the operating cash flow. It also gives investment and financing activities the same level of attention. On the other hand, free cash flow refers to the amount of liquidity left over after a company’s asset base has been maintained or spent on.
• With the use of the income statement, both cash flow and free cash flow can be determined. The indirect way of cash flow begins with Net Income, whereas the direct method starts with the company’s Sales. EBIT (Earnings before interest and taxes) is used to calculate free cash flow.
• Free cash flow cannot be computed without knowing the changes in working capital. Only CAPEX and depreciation will be taken into consideration if the working capital does not change. If the cash flow from operating activities is estimated using the direct method, it is not necessary to know the changes in working capital.
• The cash flow statement is a time-consuming and challenging task. On the other hand, free cash flow is simple to calculate (Khot & Vaidya, 2017).

References:

CFI. (n.d.). Risk – Definition, Types, Adjusment and Measurement. Corporate Finance Institute. Retrieved November 10, 2021, from https://corporatefinanceinstitute.com/resources/kn…

Khot, H., & Vaidya, D. (2017, September 21). Cash Flow vs Free Cash Flow. WallStreetMojo. https://www.wallstreetmojo.com/cash-flow-vs-free