A businesses prepare for a recession we may already be in, it’s important to understand what free cash flow (FCF) is and how it protects businesses in tough times.
Free cash flow is simply the cash a business generates after its cash outflows, such as holding capital assets. FCF represents the cash that a company has ready and available to pay creditors or send dividends to investors. As such, it’s a much more robust measure than simply looking at gross earnings.
VettaFi’s head of research Todd Rosenbluth said that “given the volatility of the market in 2022, advisers have sought out companies with strong free cash flow generation as they provide relative stability.”
If a business consistently made $100K per year, it might look healthy. But if your FHR could be constantly falling. Perhaps vendors are demanding faster and more frequent payments, or customers have fallen behind on payments. The FCF could be revealing a structural weakness in the company that a simple net income metric would be effectively masking.
Of course, declines in the FCF do not necessarily indicate that a company is in trouble. They may have purchased new equipment or made additional capital expenditures for a year to bolster their ability to meet demand or grow the business. This is why technical analysts will focus on the FCF trend instead of the absolute value.
Still, it’s a useful measure for taking stock of a company’s fundamentals. ETF like the US Quality FCF ETF (TTAC) and the International Quality FCF ETF (TTAI) Both invest in companies that have strong free cash flow characteristics, as those companies tend to be well-positioned to weather economic storms and survive tough markets. Both funds are actively managed. Rosenbluth notes that “advisors have turned to actively managed strategies in 2022 to benefit from the flexible approaches they offer. These funds take a fundamental approach to identifying high-quality companies trading at attractive levels.”