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FundamentalsIntermediate6 min

Free Cash Flow

Profit can be shaped by accounting choices. Free cash flow is the harder-to-fake number that tells you how much real cash a business produces.

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Why this matters for beginners

Cash funds dividends, buybacks, debt repayment, and reinvestment. A company with strong profits but weak cash flow is a yellow flag.

Main explanation

Free cash flow (FCF) = operating cash flow − capital expenditures. It's the cash left over after running the business and reinvesting in property, equipment, and infrastructure.

FCF tells you what management actually has to work with: paying down debt, paying dividends, buying back shares, or making acquisitions, without borrowing more.

Net income includes non-cash items like depreciation and stock-based compensation. FCF strips a lot of that out and is much harder to massage with accounting choices.

Capital-light businesses (software, asset managers) tend to convert most of their profit to FCF. Capital-heavy businesses (airlines, semiconductors, telecom) need to spend heavily just to stay in business.

Example using a real company

Microsoft generates enormous free cash flow because its software business needs relatively little capital reinvestment compared to a semiconductor fab.

  • →Operating cash flow of $50B, capex of $20B → FCF of $30B available for buybacks, dividends, and M&A.
  • →Two companies with identical net income can have very different FCF if one needs to constantly rebuild factories.

Common beginner mistakes

  • ✕Treating reported net income as the same as cash earned.
  • ✕Forgetting that heavy capex can be necessary, not bad. It depends on the industry.
  • ✕Ignoring stock-based compensation, which doesn't hit cash but does dilute shareholders.

Key terms

Operating cash flow
Cash generated by core business operations.
Capex
Capital expenditures, spending on long-lived assets like buildings and equipment.
FCF yield
Free cash flow ÷ market cap. A rough valuation gauge.

Key takeaways

  • 01FCF is what the business actually generates after staying alive.
  • 02Capital-light businesses usually convert more profit to cash.
  • 03Compare FCF to net income, large persistent gaps deserve a reason.

Check yourself

  1. 01
    Free cash flow equals net income.
  2. 02
    FCF can fund buybacks and dividends.
  3. 03
    A capital-heavy business usually has lower FCF conversion.
Apply this in the Analyzer

Try the concept on a real company

Run MSFT, AAPL, ASML and NVDA in the Analyzer. Look at the business model and valuation notes. Which businesses likely convert profit to cash easily, and which need heavy capex?

Analyze MSFT →Analyze AAPL →Analyze ASML →Analyze NVDA →

Educational examples only. Not buy or sell recommendations.

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