What Is Cash Flow Analysis?

Cash flow analysis is the process of examining the amount of cash that flows
into a company and the amount of cash that flows out to determine the net
amount of cash that is held. Once it's known whether cash flow is positive or
negative, company management can look for opportunities to alter it to
improve the outlook for the business.

What Are the 3 Types of Cash Flows?

The three types of cash flow are cash flows from operations, cash flows from
investing, and cash flows from financing.

How Do You Calculate Cash Flow Analysis?

A basic way to calculate cash flow is to sum up figures for current assets and
subtract from that total current liabilities. Once you have a cash flow figure,
you can use it to calculate various ratios (e.g., operating cash flow/net sales)
for a more in-depth cash flow analysis.

The Bottom Line

If a company's cash flow is continually positive, it's a strong indication that the
company is in a good position to avoid excessive borrowing, expand its
business, pay dividends, and weather hard times.

Free cash flow is an important evaluative indicator for investors. It captures

all the positive qualities of internally produced cash from a company's
operations and monitors the use of cash for capital expenditures.

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What Is Free Cash Flow (FCF)?
Free cash flow (FCF) is the cash a company generates after taking into consideration cash
outflows that support its operations and maintain its capital assets. In other words, free cash flow
is the cash left over after a company pays for its operating expenses (OpEx) and capital
expenditures (CapEx).

FCF is the money that remains after paying for items such as payroll, rent, and taxes, and a
company can use it as it pleases. Knowing how to calculate free cash flow and analyze it will
help a company with its cash management. FCF calculation will also provide investors with
insight into a company’s financials, helping them make better investment decisions, and can be
easily calculated using Excel or other spreadsheet software.

Free cash flow is an important measurement since it shows how efficient a company is at
generating cash. Investors use free cash flow to measure whether a company might have enough
cash for dividends or share buybacks. In addition, the more free cash flow a company has, the
better it is positioned to pay down debt and pursue opportunities that can enhance its business,
making it an attractive choice for investors.

How to Calculate Free Cash Flow (FCF)

There are several different methods to calculate free cash flow because all companies don’t have
the same financial statements. Regardless of the method used, the final number should be the
same given the information that a company provides. Three ways to calculate free cash flow are
by using operating cash flow, using sales revenue, and using net operating profits. You can also
use amortization and depreciation to account for the decreasing value of equipment and plants.1

Using Operating Cash Flow

Using operating cash flow to calculate free cash flow is the most common method because it is
the simplest and uses two numbers that are readily found in financial statements: operating cash
flow and capital expenditures. To calculate FCF, locate the item cash flow from operations (also
referred to as “operating cash” or “net cash from operating activities”) from the cash flow
statement and subtract capital expenditure, which is found on the balance sheet.

The formula is:

Free Cash Flow= Operating Cash Flow −Capital ExpendituresFree Cash Flow=
Operating Cash Flow −Capital Expenditures
Using Sales Revenue
Using sales revenue focuses on the revenue that a company generates through its business and
then subtracts the costs associated with generating that revenue. This method utilizes the income
statement and balance sheet as the source of information. To calculate FCF, locate sales or
revenue on the income statement, subtract the sum of taxes and all operating costs (listed as
“operating expenses”), which include items such as cost of goods sold (COGS) and selling,
general, and administrative costs (SG&A).

Finally, subtract the required investments in operating capital, also known as the net investment
in operating capital, which is derived from the balance sheet.

The formula is:

Free Cash Flow=Sales Revenue −(Operating Costs + Taxes) −Required Investm

ents in Operating Capitalwhere:Required Investments in Operating Capital=Yea
r One Total Net Operating Capital −Year Two Total Net Operating Capitaland
where:Total Net Operating Capital=Net Operating Working Capital +Net Plant,
Property, and Equipment(Operating Long-Term Assets)and where:Net Operatin
g Working Capital=Operating Current Assets −Operating Current Liabilitiesand
where:Operating Current Assets=Cash +Accounts Receivables+InventoryOpera
ting Current Liabilities=Accounts Payables +AccrualsFree Cash Flow=Sales Re
venue −(Operating Costs + Taxes) −Required Investments in Operating Capita
lwhere:Required Investments in Operating Capital=Year One Total Net Operati
ng Capital −Year Two Total Net Operating Capitaland where:Total Net Operat
ing Capital=Net Operating Working Capital +Net Plant, Property, and Equipme
nt(Operating Long-Term Assets)and where:Net Operating Working Capita
l=Operating Current Assets −Operating Current Liabilitiesand where:Operating
Current Assets=Cash +Accounts Receivables+InventoryOperating Current Liab
ilities=Accounts Payables +Accruals
Using Net Operating Profits
To calculate free cash flow using net operating profits after taxes (NOPATs) is similar to the
calculation of using sales revenue, but where operating income is used.

The formula is:

Free Cash Flow=Net Operating Profit After Taxes −Net Investment in Operatin
g Capitalwhere:Net Operating Profit After Taxes=Operating Income ×(1 - Tax
Rate)and where:Operating Income=Gross Profits−Operating ExpensesFree Cash
Flow=Net Operating Profit After Taxes −Net Investment in Operating Capitalw
here:Net Operating Profit After Taxes=Operating Income ×(1 - Tax Rate)and
where:Operating Income=Gross Profits−Operating Expenses
The calculation for net investment in operating capital is the same as described above.
Using Amortization and Depreciation
To calculate free cash flow another way, locate the income statement, balance sheet, and cash
flow statement. Start with net income and add back charges for depreciation and amortization.
Make an additional adjustment for changes in working capital, which is done by subtracting
current liabilities from current assets. Then subtract capital expenditure (or spending on plants
and equipment):

Free Cash Flow = Net income plus depreciation / amortization minus change in working capital
minus capital expenditure

It might seem odd to add back depreciation/amortization since it accounts for capital spending.
The reasoning behind the adjustment is that free cash flow is meant to measure money being
spent right now, not transactions that happened in the past. This makes FCF a useful instrument
for identifying growing companies with high up-front costs, which may eat into earnings now
but have the potential to pay off later.

Example of Free Cash Flow Calculation

Let's use department store Macy's to illustrate how to calculate free cash flow.

Macy's cash flow statement for the fiscal year ending 2022, according to the company’s 10-K
statement, indicates:

 Cash flow from operating activities of $1.615 billion

 Capital expenditures of $1.169 billion2

To calculate the free cash flow, we subtract capital expenditures from operating cash flow:

 $1.615B - $1.169B = $0.446B, or $446 million

We can see that Macy’s has $446 million in free cash flow, which can be used to pay dividends,
expand operations, and deleverage its balance sheet (in other words, reduce debt).

From 2020 until now, Macy’s capital expenditures have been increasing due to its growth in
stores, while its operating cash flow has been decreasing, resulting in decreasing free cash
flows.

What Free Cash Flow Can Tell You

Growing free cash flows are frequently a prelude to increased earnings. Companies that
experience surging FCF—due to revenue growth, efficiency improvements, cost reductions,
share buybacks, dividend distributions, or debt elimination—can reward investors tomorrow.
That is why many investors cherish FCF as a measure of value. When a firm’s share price is low
and free cash flow is on the rise, the odds are good that earnings and share value will be heading
up soon.
By contrast, shrinking FCF might signal that companies are unable to sustain earnings growth.
An insufficient FCF for earnings growth can force companies to boost debt levels or not have
the liquidity to stay in business.

That being said, a shrinking FCF is not necessarily a bad thing, particularly if increasing capital
expenditures are being used to invest in the growth of the company, which could increase
revenues and profits in the future.

Advantages and Disadvantages of Free Cash Flow

Pros

 Provides insight into a company's financial health

 Shows a company can pay its debts

 Can indicate future growth

Cons

 Capital expenditures can vary greatly from year to year

 High FCF may disguise a lack of investment in assets or equipment

Advantages
Free cash flow can provide a significant amount of insight into the financial health of a company.
Because free cash flow is made up of a variety of components in the financial statement,
understanding its composition can provide investors with a lot of useful information.

Of course, the higher the free cash flow, the better. But we have already seen from our Macy’s
example that a declining free cash flow is not always bad if the reason is from further
investments in the company that poise it to reap larger rewards down the line.

In addition, cash flow from operations takes into consideration increases and decreases in assets
and liabilities, allowing for a deeper understanding of free cash flow. So for example, if accounts
payable continued to decrease, it would signify that a company is paying its suppliers faster.
If accounts receivable were decreasing, it would mean that a company is receiving payments
from its customers faster.

Now, if accounts payable was decreasing because suppliers wanted to be paid quicker but
accounts receivable was increasing because customers weren’t paying quickly enough, this could
result in decreased free cash flow, since money is not coming in quickly enough to meet the
money going out, which could result in problems for the company down the line.
The overall benefits of a high free cash flow, however, mean that a company can pay its debts,
contribute to growth, share its success with its shareholders through dividends, and have
prospects for a successful future.

Disadvantages
One drawback to using the free cash flow method is that capital expenditures can vary
dramatically from year to year and among different industries. That’s why it’s critical to measure
FCF over multiple periods and against the backdrop of a company’s industry.

It’s important to note that an exceedingly high FCF might be an indication that a company is not
investing in its business properly, such as updating its plant and equipment. Conversely, negative
FCF might not necessarily mean a company is in financial trouble, but rather, investing heavily
in expanding its market share, which would likely lead to future growth.

Value investors often look for companies with high or improving cash flows but with
undervalued share prices. Rising cash flow is often seen as an indicator that future growth is
likely.

What Does Free Cash Flow Tell You?

Free cash flow tells you how much cash a company has left over after paying its operating
expenses and maintaining its capital expenditures—in short, how much money it has left after
paying the costs to run its business. Free cash flow can be spent by a company however it sees
fit, such as paying dividends to its shareholders or investing in the growth of the company
through acquisitions, for example.

Where Is Free Cash Flow in the Financial Statements?

Free cash flow is not a line item listed in financial statements. Instead, it has to be calculated
using line items found in financial statements. The simplest way to calculate free cash flow is by
finding capital expenditures on the cash flow statement and subtracting it from the operating cash
flow found in the cash flow statement.

What Is the Difference Between Free Cash Flow and Net

Cash Flow?
Net cash flow takes a look at how much cash a company generates, which includes cash from
operating activities, investing activities, and financing activities. Depending on if the company
has more cash inflows vs. cash outflows, net cash flow can be positive or negative. Free cash
flow is more specific and looks at how much cash a company generates through its operating
activities after taking into account operating expenses and capital expenditures.

The Bottom Line

Free cash flow is a metric that investors use to help analyze the financial health of a company. It
looks at how much cash is left over after operating expenses and capital expenditures are
accounted for. In general, the higher the free cash flow is, the healthier a company is, and in a
better position to pay dividends, pay down debt, and contribute to growth.

Free cash flow is one of many financial metrics that investors use to analyze the health of a
company. Other metrics investors can use include return on investment (ROI), the quick ratio,
the debt-to-equity (D/E) ratio, and earnings per share (EPS).

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Free Cash Flow (FCF): Formula to Calculate and Interpret It

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Cash Flow: What It Is, How It Works, and How to Analyze It

Cash Flow Analysis: The Basics

What Is Dilution?
Dilution occurs when a company issues new shares that result in a decrease in existing
stockholders' ownership percentage of that company. Stock dilution can also occur when holders
of stock options, such as company employees, or holders of other optionable
securities exercise their options. When the number of shares outstanding increases, each existing
stockholder owns a smaller, or diluted, percentage of the company, making each share less
valuable.

A share of stock represents equity ownership in that company. When a firm's board of directors
decides to take their company public, usually through an initial public offering (IPO), they
authorize the number of shares that will be initially offered. This amount of outstanding stock is
commonly referred to as the "float." If that company later issues additional stock (often
called secondary offerings) they have increased the float and therefore diluted their stock: the
shareholders who bought the original IPO now have a smaller ownership stake in the company
than they did prior to the new shares being issued.

KEY TAKEAWAYS

 Dilution is the reduction in shareholders' equity positions due to the issuance or creation of new
shares.
 Dilution also reduces a company's earnings per share (EPS), which can have a negative impact on
share prices.
 Dilution can occur when a firm raises additional equity capital, though existing shareholders are
usually disadvantaged.

Understanding Dilution
Dilution is simply a case of cutting the equity "cake" into more pieces. There will be more pieces
but each will be smaller. So, you will still get your piece of the cake only that it will be a smaller
proportion of the total than you had been expecting, which is often not desired.

While it primarily affects equity ownership positions, dilution also reduces the company's
earnings per share (EPS, or net income divided by the float), which often depresses stock prices
in the market. For this reason, many public companies publish estimates of both non-diluted and
diluted EPS, which is essentially a "what-if-scenario" for investors in the case new shares are
issued. Diluted EPS assumes that potentially dilutive securities have already been converted to
outstanding shares.

Share dilution may happen any time a company raises additional equity capital, as newly created
shares are issued to new investors. The potential upside of raising capital in this way is that the
funds the company receives from selling additional shares can improve the company's
profitability and growth prospects, and by extension the value of its stock.
Understandably, share dilution is not often viewed favorably by existing shareholders, and
companies sometimes initiate share repurchase programs to help curb the effects of dilution.
Note that stock splits do not create dilution. In situations where a company splits its stock,
current investors receive additional shares while the price of the shares is adjusted accordingly,
keeping their percentage ownership in the company static.

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General Example of Dilution

Suppose a company has issued 100 shares to 100 individual shareholders. Each shareholder owns
1% of the company. If the company then has a secondary offering and issues 100 new shares to
100 more shareholders, each shareholder only owns 0.5% of the company. The smaller
ownership percentage also diminishes each investor's voting power.

Real-World Example of Dilution

Often times a public company disseminates its intention to issue new shares, thereby diluting its
current pool of equity long before it actually does. This allows investors, both new and old, to
plan accordingly. For example, MGT Capital filed a proxy statement on July 8, 2016, that
outlined a stock option plan for the newly appointed CEO, John McAfee. Additionally, the
statement disseminated the structure of recent company acquisitions, purchased with a
combination of cash and stock.

Both the executive stock option plan as well as the acquisitions are expected to dilute the current
pool of outstanding shares. Further, the proxy statement had a proposal for the issuance of newly
authorized shares, which suggests the company expects more dilution in the near-term.

Dilution Protection
Shareholders typically resist dilution as it devalues their existing equity. Dilution
protection refers to contractual provisions that limit or outright prevent an investor's stake in a
company from being reduced in later funding rounds. The dilution protection feature kicks in if
the actions of the company will decrease the investor's percentage claim on assets of the
company.

For example, if an investor's stake is 20%, and the company is going to hold an additional
funding round, the company must offer discounted shares to the investor to at least partially
make up for the dilution of the overall ownership stake. Dilution protection provisions are
generally found in venture capital funding agreements. Dilution protection is sometimes referred
to as "anti-dilution protection."

Similarly, an anti-dilution provision is a provision in an option or convertible security, and it is

also known as an "anti-dilution clause." It protects an investor from equity dilution resulting
from later issues of stock at a lower price than the investor originally paid. These are common
with convertible preferred stock, which is a favored form of venture capital investment.

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Related Terms

Dilution Protection: Meaning, Types, Drawba

Return on Capital Employed (

What Is Return on Capital Employed (ROCE)?

The term return on capital employed (ROCE) refers to a financial ratio that
can be used to assess a company's profitability and capital efficiency. In
other words, this ratio can help to understand how well a company is
generating profits from its capital as it is put to use. ROCE is one of several
profitability ratios financial managers, stakeholders, and potential investors
may use when analyzing a company for investment.

KEY TAKEAWAYS

 Return on capital employed is a financial ratio that measures a

company’s profitability in terms of all of its capital.
 ROCE is similar to return on invested capital.
 It's always a good idea to compare the ROCE of companies in the
same industry as those from differing industries usually vary.
 Higher ratios tend to indicate that companies are profitable.
 Many companies may calculate the following key return ratios in their
performance analysis: return on equity, return on assets, return on
invested capital, and return on capital employed.

Understanding Return on Capital Employed (ROCE)

Return on capital employed can be especially useful when comparing the

performance of companies in capital-intensive sectors, such as utilities and
telecoms. This is because, unlike other fundamentals such as return on
equity (ROE), which only analyzes profitability related to a company’s
shareholders’ equity, ROCE considers debt and equity . This can help
neutralize financial performance analysis for companies with significant debt.
Ultimately, the calculation of ROCE tells you the amount of profit a company
is generating per $1 of capital employed. The more profit per $1 a company
can generate, the better. Thus, a higher ROCE indicates
stronger profitability across company comparisons.

For a company, the ROCE trend over the years can also be an important
indicator of performance. Investors tend to favor companies with stable and
rising ROCE levels over companies where ROCE is volatile or trending lower.

ROCE is one of several profitability ratios that can be used when analyzing a
company’s financial statements for profitability performance. Other ratios can
include the following:

 ROE
 Return on assets (ROA)
 Return on invested capital (ROIC)

Return on capital employed is also commonly referred to as the primary ratio

because it indicates the profits earned on corporate resources.

How to Calculate ROCE

The formula for ROCE is as follows:

ROCE=EBITCapital Employedwhere:EBIT=Earnings before interest and

taxCapital Employed=Total assets − Current liabilitiesROCE=Capital
EmployedEBITwhere:EBIT=Earnings before interest and taxCapital
Employed=Total assets − Current liabilities
ROCE is a metric for analyzing profitability and for comparing profitability
levels across companies in terms of capital. Two components are required to
calculate ROCE. These are earnings before interest and tax (EBIT) and
capital employed.

Also known as operating income, EBIT shows how much a company earns
from its operations alone without interest on debt or taxes. It is calculated by
subtracting the cost of goods sold (COGS) and operating expenses from
revenues.
Capital employed is very similar to invested capital, which is used in the
ROIC calculation. Capital employed is found by subtracting current liabilities
from total assets, which ultimately gives you shareholders’ equity plus long-
term debts. Instead of using capital employed at an arbitrary point in time,
some analysts and investors may choose to calculate ROCE based on
the average capital employed, which takes the average of opening and
closing capital employed for the time period under analysis.

Advantages and Disadvantages of ROCE

Pros of ROCE
There are various reasons why companies should track ROCE. ROCE
provides a comprehensive measure of a company's overall performance by
considering both profitability and capital efficiency. It helps assess the
effectiveness of capital allocation decisions and the ability to generate returns
on invested capital. Therefore, ROCE allows for meaningful comparisons
between companies operating in different industries and highlights a
company's ability to generate profits from the capital it employs.

ROCE is an important metric for investors as it reflects the company's ability

to generate returns on their investment. A consistently high ROCE indicates
that the company is generating attractive returns, which can instill confidence
in investors and potentially attract more capital.

ROCE also serves as a useful management tool for assessing the

performance of different business units or projects within a company. It helps
identify areas where capital may be tied up inefficiently and allows for better
decision-making regarding resource allocation and investment strategies.
More specifically, ROCE provides a long-term perspective on a company's
profitability and efficiency. It considers the profitability generated over an
extended period and relates it to the capital employed.

Cons of ROCE