If I told you that my checking account had four dollars in it, you would rightly conclude that I’m broke. In the business world, accounting magic means that a company can be strapped for cash but still look great on paper. Free cash flow (FCF) is a measure of how much money a company can deploy at any given time after all of the bills are paid. Investors can use this figure to get around some of the accounting magic and examine how much money a company is really making. If I tell you that my free cash flow is negative, you can rightly conclude that I’m irresponsible.
Businesses, unlike individuals, are often willing to accept negative free cash flows when they are just starting out and must spend money to build the business, or when large, expensive expansions are in the works. Investors that understand business and accounting have a decided advantage when evaluating companies with low and negative FCF. The tricky task is determining whether the deficit spending will result in future profits, or just flush money down the drain and result in bankruptcy. You will often hear the talking heads speak of this in terms of “cash burn.”
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