Why Free Cash Flow is Becoming the Go-To Measurement for Corporate Financial Health

By Erik Bratt June 11, 2018

Editor’s Note: Free cash flow has always been an important business metric, but according to new research, it’s becoming the ‘go-to’ measurement of a company’s financial health and success. The number of times the term has been mentioned in the 10Ks of non-financial S&P 500 corporations in the last 15 years has risen dramatically, according to an ongoing research project entitled, “What is Free Cash Flow?”, conducted by the Georgia Institute of Technology. We sent the study’s author, Charles W. Mulford, an Invesco Chair and professor of accounting at the institute, a few questions to find out why free cash flow is piquing the interest of CFOs and shareholders alike.

1. Thank you for agreeing to answer our questions professor. Can you tell us about your most recent research? Why is free cash flow becoming such an important financial performance metric among shareholders and modern financial executives.

The purpose of our cash flow research, which we publish on a quarterly basis, is to identify trends and the drivers behind those trends, in the ability of corporate America to generate free cash flow. Corporate financial success is dependent not only on a company’s ability to generate revenues and earnings, but also cash flow, especially free cash flow. It is free cash flow and growth in free cash flow, that discretionary stream of cash that a company can put to use for acquisitions, debt retirement, dividends and stock buybacks that works with growing earnings to drive firm value higher. Because it is “free,” free cash flow comes with no strings attached.  It is truly discretionary. Spending it does not impact the company’s ability to generate more. A company with revenue growth will eventually lose the favor of investors if it never finds a way to generate earnings. In a similar way, a company with profits that is unable to generate cash will also experience waning investor enthusiasm. It may take a while. Investors are patient with profitable, growing companies. Ultimately, however, a company must show an ability to generate free cash flow.

2. Do you see this trend – the focus on free cash flow – continuing?

CFOs are taking note of the importance of free cash flow. References to the metric in corporate annual reports have increased over 200 percent in the past 15 years. We think that this trend and the acknowledgement of free cash flow as a key measure of financial performance will continue. 

3. Because it is outside GAAP, there is no standard definition for free cash flow. How do you define it?  

Free cash flow is not defined by GAAP. Our research indicates that most firms define it as cash provided by operating activities, as defined by GAAP, less dividends on preferred and less capital expenditures. 

4. Do you have examples of what some companies are doing with their free cash flow.

Given that it is discretionary, free cash flow may be used for any corporate purpose. The press is replete with examples of companies using their free cash flow to increase dividends and stock buybacks. The big question is whether some of that free cash might be used for increased capital spending, which would help boost the economy and employment. As of yet, our data have not indicated that CFOs are increasing their capital budgets. 

5. What methods and best practices do CFOs have at their disposal to improve free cash flow?

There are many levers that a CFO may pull to increase free cash flow. Operating margins play a significant role, as does minimizing working capital needs, especially receivables and inventory, while maximizing payables. Taxes also play a big role and reduced taxes through tax reform should serve to increase free cash flow. Finally, CFOs must find the right level of capital spending – sufficient to maintain growth, but not overly so as to be wasteful.

Editor’s Note: one of the technology levers that a CFO has at his or her disposal to increase free cash flow and improve working capital, is a supply chain finance solution. Find out more about Kyriba’s cloud-based SCF solution.

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