When I was growing up, my grandfather would get me confused with my cousin Tim – so quite frequently, Tim would be called Michael and I would be called Tim. We were quite different but similar enough that we would be confused with each other. In the same way, often times in a conversation about shareholder value or cash flow, free cash flow will get confused with EBITDA although they are quite different and important to understand.
Free cash flow is operating cash flow less capital expenditures. Another way to look at it is EBITDA, plus changes in working capital (inventory, accounts receivable, accounts payable and other current assets/liabilities) less capital expenditures. It is an indicator of the ability of a business to fund enhancements after paying for investments to sustain itself. Often times, capital expenditures are split between maintenance capital, which is capital required to sustain a base operation, and non-maintenance capital, which is capital to enhance the value of the firm.
The more free cash flow, the better for the company. Some of the enhancements are acquisitions or new product lines or new locations or dividends or debt repayment – all items which increase the shareholder value of the firm. As such, it is important to understand what free cash flow is and the underlying drivers to improving it. Taking actions to improve your base business – such as sales price optimization, productivity improvements, prioritizing your maintenance capital based on return and other cost optimization actions – will generate the necessary free cash flow to take your business – and your shareholder value – to the next level.