How quality companies generate free cash flow?

Cash flow is the lifeblood of any business.

There have been numerous companies that seemed to be very profitable, but were teetering on the edge of bankruptcy because they couldn't turn their profits into cash fast enough.

Profits and cash flow are not the same thing, and it is not sufficient for a company to be profitable to make it a good investment.

After finding out that a company is profitable, is to see how good that company is at turning its profits into cash flow.

A company's future free cash flow is the ultimate determinant of how good an investment the company will be.  Cash flow is the key determinant of its share price and the size of the dividend it will pay out to shareholders - which are the two elements that comprise the total returns from owning a share.

Free cash flow to the firm (FCFF)

Cash flows from operating activities + dividends received from joint ventures - tax paid  = net cash flow from operations

Net cash flow from operations - capex = FCFF

Free cash flow for shareholders (FCF) or Free cash flow for equity (FCFE)

FCFF - net interest (interest received - interest paid) - preference share dividends - dividends to minority shareholders = FCF

How can you use free cash flow numbers to identify good companies to invest in and bad ones to stay away from? 

A company with very little debt and a tiny interest payment, virtually all of the FCFF become FCF or FCFE.  In other words, there is not much difference between FCFF and FCF or FCFE.   This is a positive sign for investors and you should look for this sort of situation in companies you are analysing.

In contrast, a company with lots of borrowings and therefore interest bills to pay, the FCFF and FCF or FCFE will be different.   The interest payment has eaten up a big chunk of the company's FCFF, leaving less FCF or FCFE for shareholders.  In general, it is a good idea to avoid companies with lots of debt.  Too much of their FCFF can end up being paid in interest to lenders instead of to shareholders.

The one possible exception to this rule is when companies are using their FCFF to repay debt and lower their future interest bills.  This can see FCF to shareholders increasing significantly in the future, which can sometimes make the shares of companies repaying debt good ones to own.

Look for a company with vey good long-term track record of producing free cash flow for its shareholders.

Companies that produce lots of free cash flow can make excellent investments.