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    Effect of Free Cash Flow On Profitability of Firms

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    Mohsin Jutt
    High levels of free cash flow can be attractive to investors as it signals that a company has excess cash that can be used for growth opportunities, paying dividends, or reducing debt. Free cash flow is calculated by taking a company's net income plus depreciation and subtracting capital expenditures and changes in working capital. Maintaining an appropriate level of free cash flow is important for companies' liquidity and financial flexibility. Profitability ratios are also important measures, assessing a company's ability to generate profits through margins and returns on assets and equity. High or rising levels of free cash flow and profitability are often seen as signs of a healthy, well-performing company.

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    Effect of Free Cash Flow On Profitability of Firms

    Uploaded by

    Mohsin Jutt
    266 views5 pages
    High levels of free cash flow can be attractive to investors as it signals that a company has excess cash that can be used for growth opportunities, paying dividends, or reducing debt. Free cash flow is calculated by taking a company's net income plus depreciation and subtracting capital expenditures and changes in working capital. Maintaining an appropriate level of free cash flow is important for companies' liquidity and financial flexibility. Profitability ratios are also important measures, assessing a company's ability to generate profits through margins and returns on assets and equity. High or rising levels of free cash flow and profitability are often seen as signs of a healthy, well-performing company.

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    Effect of Free Cash Flow on Profitability of Firms

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    High levels of free cash flow can be attractive to investors as it signals that a company has excess cash that can be used for growth opportunities, paying dividends, or reducing debt. Free cash flow is calculated by taking a company's net income plus depreciation and subtracting capital expenditures and changes in working capital. Maintaining an appropriate level of free cash flow is important for companies' liquidity and financial flexibility. Profitability ratios are also important measures, assessing a company's ability to generate profits through margins and returns on assets and equity. High or rising levels of free cash flow and profitability are often seen as signs of a healthy, well-performing company.

    Copyright:

    © All Rights Reserved
    Download as DOCX, PDF, TXT or read online from Scribd
    Download as docx, pdf, or txt
    266 views5 pages

    Effect of Free Cash Flow On Profitability of Firms

    Uploaded by

    Mohsin Jutt
    High levels of free cash flow can be attractive to investors as it signals that a company has excess cash that can be used for growth opportunities, paying dividends, or reducing debt. Free cash flow is calculated by taking a company's net income plus depreciation and subtracting capital expenditures and changes in working capital. Maintaining an appropriate level of free cash flow is important for companies' liquidity and financial flexibility. Profitability ratios are also important measures, assessing a company's ability to generate profits through margins and returns on assets and equity. High or rising levels of free cash flow and profitability are often seen as signs of a healthy, well-performing company.

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    © All Rights Reserved
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    Download as docx, pdf, or txt
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    EFFECT OF FREE CASH FLOW ON PROFITABILITY OF FIRMS

    Background of the Study


    Companies that have high free cash flow are likely to attract investors that look for
    efficient opportunities to invest their additional resources in the market. Creditors
    and investors are willing to invest in companies that have high free cash flows
    because the strength of debt kickback and the definition of financial flexibility of
    the company are the means for assessing these companies. In addition, cash profits
    and debts reduction are not possible without possession of cash paying. The free
    cash flows theories were introduced in 1986 for the first time by Jensen and it
    gradually evolved, as one of the new topics in the financial literature which
    describes the behavior of companies that is not justifiable with previous economic
    theories (Griffith & Carroll, 2001).
    Free cash flows is one of the key tools for measuring the financial performance of
    business unit and shows the cash that company has after performing the
    necessary costs for maintenance or development of assets (Habib, 2011).Free
    cash flows can have important applications for shareholders in assessing the
    financial soundness of the business unit. The managers who invest free cash flows
    in projects with positive net present value (NPV) as a result of efficient use from
    their owned resources contribute to the increase of the firm value. Firms have a
    choice between internal and external sources to finance their investments.
    Internal sources include retained earnings and depreciation, while external
    sources refer to debt and equity (Jensen & Smith, 2005).

    Free Cash Flow


    Free cash flow is a measure of how much cash a business generates after
    accounting for capital expenditures such as buildings or equipment. This cash can
    be used for expansion, dividends, reducing debt, or other purposes. Free cash flow
    show the amount of cash the company allocates or budgets after spending for
    maintenance or development of property. Free cash flow is a cash flow available
    for capital provider, which is for reinvestment, after fulfilling the requirements of
    the business, such cash flow which is extra or free, is referred to as free cash flow.
    Free cash flow (FCF) can also be defined as cash available for resource provider
    (equity or debt provider). Jensen (1986) defines free cash flow as cash in excess of
    that which is required to fund all positive net present value projects. Free cash flow
    is a firm’s net income plus depreciation/amortization and all other non-cash
    charges minus changes in working capital and expenditure. Free cash flow is the
    amount of cash left after paying the bills and making new investment and on -
    going capital improvements. Earnings include plenty of non cash components such
    as depreciation of equipment, armotisation of capital expenditures, provision of
    bad debts and other accounting entries which may or may not reflect current
    economic reality. Earnings can be manipulated whereas free cash flow is very
    difficult to manipulate.
    Investors should also be aware that companies can influence their free cash flow by
    lengthening the time they take to pay the bills (thus preserving their cash),
    shortening the time it takes to collect what's owed to them (accelerating the receipt
    of cash), and putting off buying inventory. It is also important to note that
    companies have some leeway about what items are or are not considered capital
    expenditures, and the 3
    investor should be aware of this when comparing the free cash flow of different
    companies (Jensen & Michael, 1996).
    Maintaining suitable amount of liquidity within the firms is fundamental for the
    smooth operations of firms. Managers have a propensity to hold large percentage
    of firm assets in the form of cash and cash equivalents in order to reinvest on
    other physical assets, payments to stockholders and to keep cash inside the firm
    (Hann, Ogneva & Ozbas, 2010).The level of cash a firm maintains is described by
    its policies regarding capital structure, working capital requirements, cash flow
    management, dividend payments, investments and asset management. (Jensen,
    2000), defines free cash flow as cash flow in excess of what is required to fund
    positive NPV investments. Free cash flow is a sign of agency problems because
    excess cash may not be returned to shareholders. When firms have free cash, any
    acquisitions made by these firms are, by definition, negative net present value.
    Free Cash Flow can be expressed as: FCF=EBIT (1-Tax) + Depreciation ± Change in
    W.C- Capital Expenditure

    The presence of free cash flow indicates that a company has ash to expand,
    develop new products, buy back stock pay dividends, or reduce its debt. High or
    rising free cash flow is often a sign of a healthy company that is thriving in its
    current environment. Furthermore, since FCF has a direct impact on the worth of
    a company, investors often hunt for companies that have high or improving free
    cash flow but undervalued share prices -- the disparity often means the share
    price will soon increase.

    Free cash flow measures a company's ability to generate cash, which is a


    fundamental basis for stock pricing. This is why some people value free cash flow
    more than just about any other financial measure out there,
    including earnings per share.

    PROFITABILITY
    and sometimes they pay managers for reaching them, but the goals of firms are broader than their
    profits alone (Chandra, 2002).
    One of the most frequently used tools of financial ratio analysis is profitability ratios which are used
    to determine the company's bottom line and its return to its investors. Profitability measures are
    important to managers and owners of the firm since they show the overall efficiency and
    performance of firms. Profitability ratios can be divided into two types namely margin and returns
    (Petersen and Kumar.2010). Ratios that show margins represent the ability of the firm to translate
    sales into profits at various stages of measurement. Ratios are essential tools for measuring
    profitability of firms because they illustrate the ability of the firm to measure its overall efficiency in
    generating returns to its shareholders (Khan & Jain, 2003).
    Margin Ratios are used in measuring the profitability of a firm for instance gross profit margin which
    looks at the costs of goods sold as a percentage of sales. The other measure is operating profit
    margin also known as EBIT which measures the overall efficiency of the manufacturing firm
    (Maheshwari, 2001).The other measure of profitability in manufacturing firms is return on assets
    ratio which measures efficiency with which the company is managing its investment in assets and
    using them to generate profit. It measures the amount of profit earned relative to the firm's level of
    investment in total assets. The other measure of profitability is return on equity ratio, this measure
    of profitability is significant in measuring the return on the money the investors have put into the
    manufacturing firm which is a ration of net income divided by stockholders equity (James et al.,
    2005).

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