Looking for a good investment opportunity? Pay attention to a company’s free cash flow

Julie Brownlee, Fsp Invest, 03 Mar. 2015

Tags: free cash flow, what is free cash flow, how to calculate free cash flow, investing, investing for dividends,

If you’re looking for a good long-term investment, chances are you want dividends as well as a rising share price.

One way to gauge the health of a company and check the chances of a company maintaining its dividends is to check its free cash flow.

So what is free cash flow?

Read on to find out…

What is free cash flow?

Free cash flow measures a company’s ability to generate spare cash. The company can return this cash to its shareholders in dividends or use it to pay off debt.

Free cash flow is the actual money a company has left after it pays all its expenses and investments.

There are different ways to calculate a company’s free cash flow. Some include interest payments, whilst other ignore don’t.

How to calculate free cash flow

The most common way to measure free cash flow is to:

  • Take a company’s profits before interest payments;
  • Add depreciation and amortisation to that; and
  • Minus capital expenditure.

Depreciation and amortisation are accounting measures to reflect the falling value of assets over time. But these measures are vulnerable to manipulation.

So free cash flow removes these measures to try to give a truer picture of how a company’s doing. This will hopefully mean you can avoid investing in companies that are always seeking fresh capital injections.

But you shouldn’t discount a company just because it has low free cash flow. This could be due to a company growing rapidly, but over the long-term it could be a good investment.

You may find that a company includes free cash flow in its accounts. If not you’ll have to calculate it for yourself.

So there you have it, why you should pay attention to a company’s free cash flow.

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