Introduction

Free cash flow (FCF) and net income are key indicators for evaluating a company's performance, but each provides different information. While net income may look attractive as a metric, FCF is a better indicator of the company's true economic strength and cash flow.

Definitions and Calculations

Net Income

Net income measures the total profit of a company after deducting all expenses, including operating costs, interest, and taxes. The formula for calculating net income is:

Net Income = Total Revenue - Total Expenses

For example, Apple Inc. (AAPL) reported a net income of 94 billion USD for the fiscal year 2021.

Free Cash Flow

Free cash flow, on the other hand, represents the cash that a company has available after spending on operations and capital expenditures. The formula for calculating FCF is:

FCF = Net Cash Flow from Operating Activities - Capital Expenditures

For instance, Microsoft Corp. (MSFT) reported FCF of 56 billion USD in 2021, showcasing its strong cash generation ability.

Difference Between FCF and Net Income

Cash vs. Accounting

• Net income includes non-cash items such as depreciation and reserves, which can distort the actual financial situation. For example, a company can report high net income while facing liquidity issues.
• FCF focuses directly on cash that is truly available, which is crucial for operations and investments.

Ability to Fund Growth

• Net income may be positive, but if FCF is insufficient, the company may face challenges funding its development projects. For example, ČEZ a.s. might have a high net income but insufficient FCF to finance new power plants.
• FCF is essential for dividend payouts, share buybacks, and meeting changing operational needs.

Greater Emphasis on Stability

Warren Buffett is known for emphasizing free cash flow when evaluating investments. He believes that healthy FCF is a key indicator of a company's ability to maintain a stable and continuous cash inflow, necessary for long-term success.

Why Does Buffett Prefer FCF?

1. Long-term Sustainability: FCF indicates whether a company can survive and invest in its future without needing to increase debt.
2. Reality vs. Accounting: Buffett believes that paper numbers can often be misleading, and FCF offers a clearer picture of financial health.
3. Attractiveness to Investors: Companies that generate consistent FCF tend to attract more investors, which increases their stock price.

How to Monitor FCF? Using QMA

On the QMA platform, you can easily monitor free cash flow and other key metrics through:

• 5-pillar score: Evaluate overall performance of companies, including their FCF.
• Smart Money: Allows you to track where institutional investors are investing, which can indicate quality companies with good FCF.
• Screener: This feature helps you find stocks based on various criteria, including FCF.
• QMA-picks: Filtered stocks with high FCF.
• Portfolio-health: Helps you assess the strength of your portfolio in the context of cash flow.

Conclusion

When looking at a company's overall financial performance, free cash flow is a crucial indicator that can signal long-term viability and cash generation ability. When investing in stocks, whether it’s AAPL, MSFT, or ČEZ, don’t forget to thoroughly analyze FCF and compare it to net income.

Where to find this in QMA

You can track free cash flow and other financial indicators on the QMA platform in the analytics tools section. Make sure to regularly update your portfolios and assess the health of your investments.

Disclaimer

This article is for informational purposes only and does not constitute financial advice. Always do your own research and consider consulting an expert before making investment decisions.