Chartered Financial Analyst (CFA) Practice Exam Level 2

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What is a key characteristic of FCF models?

They depend on dividend history
They are suitable for firms with stable funding policies
FCF is related to profitability
They exclude controlling shareholders from analysis

The correct answer is: FCF is related to profitability

A key characteristic of Free Cash Flow (FCF) models is that FCF is intrinsically related to a company's profitability. Free cash flow represents the cash generated by a company that is available for distribution among all the securities holders. It is calculated as operating cash flow minus capital expenditures. This aspect of FCF models highlights a company's ability to generate cash from its operations after accounting for the investments needed to maintain or expand its asset base. When a company's profitability is high, it typically leads to higher free cash flow, assuming capital expenditures remain constant. Thus, the relationship between FCF and profitability helps investors assess the financial health of a firm and its ability to generate cash, which is crucial for valuation and investment decisions. Understanding this relationship is fundamental for analysts because it provides insights into how efficiently a company converts its revenue into actual cash that can be utilized for growth, debt repayment, or returning capital to shareholders.