Learning Mathanese: How to Calculate Free Cash Flow (and Why It Matters))
byNov 4th 2011 10:30AM
Math. It's a four-letter word you can say on TV, yet it's so reviled that people go lengths to avoid it, even when they know that doing so puts their financial well-being in peril.
Wait! Don't click away. Today brings part three in a continuing series that spotlights the major computations found here at DailyFinance. Or, as we'll call it, a short course in Mathanese -- aka, the numbers behind investing's (and life's) big equations.
Don't worry, there's nothing too complicated here, despite how difficult and intimidating professional money managers and Wall Street talking heads make it seem. We're talking about math most 10-year-olds have learned upon graduating fifth grade.
Last time, we covered working capital. Today, we're onto the equally important free cash flow.
When Moola Rolls In, Shareholders Win
While earnings get the headlines -- as in, OpenTable (OPEN) reported 30 cents in earnings per share during the third quarter -- it's free cash flow that tells shareholders just how much cold, hard cash a business is producing.
Unfortunately, we don't yet know how OpenTable did in this area because it didn't publish a statement of cash flows in its quarterly press release. (Boooooooooooo.)
Just as the income statement describes how good a business is at producing profits and the balance sheet depicts financial stability, the cash flow statement reveals how much cash is needed to fund a company's operations. Free cash flow is what's left over after all operational needs -- typically referred to as "capital expenditures" -- are met.
How to figure it? Easy. On the cash flow statement, subtract capital expenditures from cash from operations. Here's the equation:
[Cash from operations – capital expenditures]
And here's the equation when you plug in the numbers for a well-known cash producer like IBM (IBM), which as you'll see has produced billions in excess cash through the first nine months of the year, all of which can be used for funding dividends, share buybacks, or new initiatives:
$10.64 billion – $3 billion = $7.64 billion
Why You Should Care About This Number
Free cash flow matters because cash matters. Businesses that have it are more likely to survive dire economic downturns. They also have the flexibility to purchase competitors or fund big deals, as Google (GOOG) did recently when it allegedly committed $100 million to turn YouTube into a full-fledged cable TV alternative.
Conversely, when cash is sparse, struggling businesses find themselves either begging for help -- as Clearwire (CLWR) is right now -- or taking on debt at unfavorable or even catastrophic terms. Either way, shareholders lose.
Have questions or comments? Please let us know using the comments box below. You can also notify Tim by replying to him on Twitter, where he posts as @milehighool.
Motley Fool contributor Tim Beyers owned shares of Google and IBM at the time of publication. The Motley Fool owns shares of International Business Machines, Google, and OpenTable. Motley Fool newsletter services have recommended buying shares of Google and OpenTable.