Bangalore: Do you remember the story of the three little pigs? The first little pig built his house with straw, only to see the wolf blow it down. The second pig built his house with sticks and suffered the same fate. The third pig built his house with bricks. The big, bad wolf huffed and puffed, but he couldn't blow it down. So what's the lesson investors can draw from this story? Well, it is that in corporate finance, cash is the equivalent of bricks. In fact, smart investors lay a lot of emphasis on companies that generate a plenty of cash as these are in the best position to withstand the huffing and puffing of a slowing economy and competition. The best thing about cash - that most companies often overlook - is that it has 'optionality'. Having cash on hand in a volatile market gives you the flexibility to purchase assets in the future at discounted prices. Cash is best when it's 'free' The best things in life are free, and the same holds true for cash. Smart investors love companies that produce plenty of free cash flow or FCF. But what exactly is FCF? Well, let me help you with a simple explanation. To produce sales or operating revenue, a company incurs operating expenses. Like it spends money as salaries for employees, sales and marketing costs, and research and development costs. The difference between operating revenue, that is what the firm receives from customers on selling its products or services, and operating expense, the list of things above, is called Operating Income or Net Operating Profit (NOPAT). Operating Revenue - Operating Expenses = Operating Income or Net Operating Profit Now, apart from the above-mentioned expenses, a company also must buy machinery, buildings, tools, and other things. It must invest money in real estate, buildings, and equipments. Also, the company needs to buy inputs for its production. It has to buy steel if it wants to produce cars. In financial terms, a firm has to purchase working capital to support its business activities. On top of that, a company must pay income taxes on its earnings. The amount of cash that is left over after the payment of all these expenses, investments, and taxes is known as Free Cash Flow or FCF. NOPAT - Change in Working Capital - Capital Expenditure = Free Cash Flow A high and rising FCF generation signals a company's ability to pay debt, pay dividends, buy back stock and facilitate the growth of business - all important things from an investor's perspective. When a company's share price is low and FCF is on the rise, there are great chances that earnings and share value will soon be on the up. By contrast, falling FCF signals trouble ahead. In the absence of decent FCF, companies are unable to sustain earnings growth as they don't have much of free cash for growth and expansion. An insufficient FCF for earnings growth can force a company to boost its borrowing levels. Even worse, a company without enough FCF may not have the liquidity to stay in business.