Want to check if a company has enough money left in the pot to pay dividends? Look at its free cash flow

Julie Brownlee, Fsp Invest, 18 Sep. 2014

Tags: free cash flow, what is free cash flow, valuing shares, dividends, profits, checking dividends,

If you’re an income investor, your main focus is investing in companies that pay dividends. Of course, you can’t predict into the future what’s in store for a company, but you can check how it’s looking cash wise.

One of the best ways of doing this is to look at a company’s free cash flow. Using this figure instead of earnings or profits is a more reliable way of seeing how the company is performing. And if it has enough money to pay dividends.

So what is free cash flow? And how can you calculate a company’s free cash flow?

Let’s take a closer look…

The pitfalls of using profits to judge a company

A company can essentially fudge its profit and earnings numbers.

For instance, profits use the opinions of company directors to work out things like how long certain assets will last. This is known as depreciation.

But there’s another figure you can use that’s far more reliable. And this figure isn’t subject to any guesswork.

The advantages of using free cash flow

A company can’t manipulate its cash flow in the same way it can its profits and earnings.

Free cash flow is the cash a company has left over once it’s settled all its bills.

In other words, free cash flow is the amount of surplus money a company has once it pays for all of its non-discretionary costs.

How to calculate free cash flow

Some companies will provide the free cash flow figure for you in their accounts. But if it’s not there, here’s how you can calculate it…

Looking at a company’s cash flow statement, take the operating cash flow. From that figure minus interest paid, tax paid and any capital expenditure costs (this is money a company spends on new assets).

To that figure, add in any interest and dividends the company receives, plus any money the company raised from selling assets.

And that’s your free cash flow figure.

You can use the free cash flow figure to see if a company has enough cash to pay dividends. And you can use the figure to value a company. Read here to find out more.

So there you have it, how to check if a company has enough money left in the pot to pay dividends.

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