Question

Analysts calculated that Starbucks total free cash flow for the months ended in June 2017 was $763 million. Its net income for the months ended in June 2017 was $692 million. From class, what is the definition of free cash flow? If you are considering an investment in SBUX, should you be more interested in free cash flow or net income?

Answer 1

Net income and free cash flow are similar in their purpose, measuring a company’s earnings.

Net income is calculated by subtracting cost of sales, operational expenses, depreciation, amortization, interest, and taxes from total revenue. Also called accounting profit.

Free cash flow is a measure of cash entering and leaving the operations of the business. It’s a way to access if the company has enough capital to sustain itself, and the cash flow available for distributions. This measure is calculated by starting with net income, adding amortization and depreciation, then deducting the change in working capital and capital expenditures.

Free cash flow (FCF) measures a company’s financial performance. It shows the cash that a company can produce after deducting the purchase of assets such as property, equipment, and other major investments from it’s operating cash flow. In other words, FCF measures a company’s ability to produce what investors care most about: cash that’s available be distributed in a discretionary way.

Free Cash Flow is not defined by U.S. GAAP and, contrary to Net Income, it is measured on a “cash”, not accrual basis. This means that any non-cash charges are added back and any unrecognized revenues are as well.

Knowing the company’s free cash flow enables management to decide on future ventures that would improve the shareholder value. Additionally, having an abundant FCF indicates that a company is capable of paying their monthly dues. Companies can also use their FCF to expand business operations or pursue other short-term investments.

Compared to earnings per se, free cash flow is more transparent in showing the company’s potential to produce cash and profits.

Meanwhile, other entities looking to invest may likely consider companies that have a healthy free cash flow because of a promising future. Couple this with a low-valued share price, investors can generally make good investments with companies that have high FCF. Other investors greatly consider FCF compared to other measures because it also serves as an important basis for stock pricing.

Free Cash Flow is more favourable for Investment than Net Income.