Looking at the Measures

Let's look at each of these measures.

Profit is the traditional measure of wealth creation. One can describe profit as a common sense measure, "Was anything left over after we subtract expenses from revenues?" However, profits are limited in two ways.

• Profits do not look at issues related to additional investment. For example, your CFO comes to you and says, "Boss, I have good news and bad news. The good news is that we made a profit of $10 million. The bad news is we need to invest $15 million into new plant and equipment to stay competitive next year."
• Profits are not directly accessible to stockholders. Owners have only two ways to get the wealth that has been created, dividends and stock appreciation.

Free Cash Flow addresses the first problem. One can describe Free Cash Flow as the money left after investment that a company could either put in the bank or give to shareholders.

Consider "Cash Flows From Operations" from the Cash Flow Statement. It consists of Net Income (that is, profits, the results from the Income Statement), Depreciation (typically we can ignore any "extraordinary" items), and fluctuations in A/R, A/P, and Inventory.

In practice, A/R and A/P tend to cancel each other out (a loan to customers versus a loan from vendors). They rarely fluctuate enough to cause serious damage to cash flow, although they do consume some wealth over the long haul, growing at about the rate of industry growth.