Negative Free Cash Flow – Causes and Meaning

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What Is Free Cash Flow?

Free cash flow is the amount of cash within a company that is left after accounting for all operating expenses, reinvestment needs, and non-cash adjustments. It is essentially the money that could theoretically be distributed to all shareholders of the business at the end of the day. 

Unlike net income, free cash flow represents the actual amount of cash that a business has left and can be different from net income since that is an accounting metric that is adjusted by various accrual accounting principles.

 

Even though free cash flow as a measure doesn’t belong to the generally accepted accounting principles (GAAP), it is still a widely used metric both by investors and companies to measure performance and profitability. 

 

How Is Free Cash Flow Calculated?

The general formula for FCF is:

 

Calculating free cash flow is a pretty straightforward process. Simply start at the operating cash flow located at the cash flow statement of a business and subtract out the capital expenditures ( often referred to as investments in property plant and equipment) from it. 

 

We start at the operating cash flow in our calculation because it represents the pure cash flow coming from the company’s operations by adding any non-cash expenses (such as depreciation) and adjusting for changes in working capital to the net income figure. 

 

We start at the operating cash flow in our calculation because it represents the pure cash flow coming from the company’s operations by adding any non-cash expenses (such as depreciation) and adjusting for changes in working capital to the net income figure. 

 

Example of Negative Free Cash Flow

Company A has reported positive earnings of $150 million for the most recent quarter. Because those earnings are adjusted based on various accounting principles, they don’t represent the actual amount of cash that the business has generated. Therefore, non-cash expenses such as $20 million in depreciation and amortization, $10 million in stock-based compensation (money that the company paid to employees in form of equity, and $3 million in deferred income taxes (taxes that the company will pay in the future) are added back to net income.

As a result, company A’s operating cash flow is $183 million. However, the business also spent $200 million in acquiring new fixed assets reported as capital expenditures in the quarter. To arrive at free cash flow, we would need to subtract the CapEx from the operating cash flow which would lead us to a free cash flow of -$17 million.

How Can Companies Have Negative Free Cash Flow?

A company can report negative free cash flow in two of the following cases:

1. When the capital expenditures (CapEx) that the business has to make, outweigh the amount of cash that it generates from operations (CFO).

In other words, if a business has to spend more money on maintaining and acquiring assets than the amount of cash that it receives from its operations, its free cash flow will be negative. This can often apply to capital-intensive businesses such as companies that are operating in energy, transportation, or auto manufacturing industries.

Example: NextEra Energy, Inc.

NextEra Energy (NEE) is an American electric utility company with a market capitalization of roughly $145B. The company reported a positive operating cash flow of $7.38B in the most recent quarter. Its capital expenditures, however, were double the amount of its cash flows from operations. As a result, the free cash flow figures for NextEra Energy were negative for the past few years. 

2. When the reported operating cash flow is negative, to begin with as a result of negative earnings.

If a company generates negative profits that also don’t result in a positive operating cash flow after adjusting for non-cash expenses, the business will report negative free cash flow.

Example: Snap Inc.

Snap Inc. (SNAP) which is primarily known for Snapchat, – its camera messaging application had its IPO in 2017 and now trades at a market capitalization of roughly $100B. Snap’s operating cash flow has been negative over the recent years but as the company’s revenues are growing immensely, cash flows have just tipped to the positive side recently. 

As cash flows from operations were negative in the first place, the company has noted negative free cash flows over the last twelve months before reporting a positive FCF of $126 million in Q1 2021.

How to Interpret Negative Free Cash Flow

A negative free cash flow doesn’t necessarily have to be a bad sign, to begin with. Younger companies will usually report negative free cash flow as a result of constant reinvestments that have to be made in order to finance growth. In the optimal case, a negative cash flow right now would then be compensated with accelerated growth in the future.

Negative free cash flow can be a “good” sign when the reinvestments that the company makes, are showing positive signs of success. Such positive signs could be accelerated revenue growth and increasing margins.

In order to properly assess a negative free cash flow of a given company, we would need to dive deeper into the company’s specific circumstances:

Assessing the company in its corporate life cycle. In which stage of its business lifecycle does the company find itself? Are we currently dealing with a young growth business where negative cash flows aren’t uncommon or a mature business that somehow struggles with generating profits?

Determining what exactly led to the negative free cash flow. Does the business generate negative operating cash flow in the first place or did a lot of money flow into capital expenditures? Is the company operating in a capital-intensive business by its nature?

What kind of investments did the company make? Capital expenditures often require a lot of capital which usually involves the act of taking on additional debt. Since any poorly invested capital can have negative financial consequences in the future, it is important to pay close attention to the amount of CapEx that the company makes. Information about how a company funds its capital expenditures and where management decides to spend it can typically be found in the annual report of the business.

At the end of the day, free cash flow should really be viewed as money that could theoretically be distributed to shareholders or reinvested back into the business. If a mature and slow-growing company itself doesn’t aim to achieve higher growth, any additional money that is spent on reinvestments instead of profit returns may be considered a bad choice.

Nonetheless, it is worth noting that negative cash flows can certainly be a problem but shouldn’t immediately raise a red flag for most investors without further investigation.

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