In the sphere of corporate finance and investment analysis, free cash flow is considered to be one of the most crucial indicators to address. Unlike earnings or net income, which can be interwoven with accounting decisions, cash flow, in its turn, has the potential to shed more light upon the financial health of a business. Formally, free cash flow is defined as the cash, left in the company’s disposal as soon as all capital expenditures, and operating costs are paid.
This guide consists of all core aspects one has to consider when dealing with this concept, including the relevant formulas.
What is Free Cash Flow?
As it has been mentioned above, free cash flow is the cash left in the disposal of the company after paying absolutely all operating expenses and investments in fixed assets. In other words, it measures the funding reserve of a particular firm.
As stated in the Investopedia, free cash flow essentially is “a glimpse into a company’s sustainability and long-term growth outlook”. The balance reflecting cash impulses serves as a good proof of the ability of a company to boost productivity and fund growth. The surplus of the cash available to spend may be directed towards paying out dividends, reducing debts, or reinvesting in the business.
Why “Free Cash Flow” Matters
There are several reasons why free cash flow is so widely used in financial analysis:
- It indicates real profitability: As many experts claim, income may be affected by too many accounting procedures, which would not be the case with cash. Free cash flow reflects real liquidity.
- Debt repayment potentials: It is a clear yardstick for measuring the ability of a company to manage its debts. With FCF, it is simpler to pay off debts and creditors. Follow the link to know more about FCF.
- Dividend sustainability: If a company consistently produces more free cash flow than it pays in dividends, those payouts are likely sustainable.
- Valuation purposes: FCF is a core part or component in discounted cash flow models used to infer the intrinsic value of a business.
Financial statement analysis: investors and various participants use these indicators to compare companies’ performance.
Calculation of FCF yields and some operational indicators.
The Formula
The formula for FCF is general and simple:
“Free cash flow = operating cash flow – capital expenditures”.
As seen, two main components are used in this expression. The first component of this formula that comprises cash is derivative from a few cash flow statements of companies. The second part of this expression represents capital expenditure or capital expenditures. It is an essential item that is described in a company’s cash flow statement and clearly resembles cash outflows from the company to maintain, develop, and acquire physical assets, such as property, buildings, or equipment.
Overall, there exist two main versions of the free cash flow formula: a primary version that starts from the first main component and a secondary version that starts from net income:
FCF = Net Income + Non-Cash Expenses – Change in Working Capital – Capital Expenditures.
This version is used to estimate all company’s free cash flow when companies do not provide full cash flow statements. The second version lets an author or any other person who works with this indicator to differentiate or separate and critically analyse the influence of each element used in both parts of the expression.
How to Calculate Free Cash Flow?
Let’s walk through a real-world example to see how to calculate free cash flow.
Example:
Imagine a company has the following financial data:
- Net Income: $500,000
- Depreciation & Amortisation: $100,000
- Change in Working Capital: $50,000
- Capital Expenditures: $150,000
We’ll use the detailed FCF formula:
- FCF = Net Income + Depreciation – Change in Working Capital – CapEx
- FCF = $500,000 + $100,000 – $50,000 – $150,000 = $400,000
So, the company has a free cash flow of $400,000.
This tells us that after all operational costs and reinvestments into the company, there is $400,000 of cash remaining that can be used at management’s discretion.
Using the Cash Flow Statement for FCF
In order to find free cash flow directly on the cash flow statement, one should:
- Find Net Cash Provided by Operating Activities, which is your operating cash flow.
- Locate Capital Expenditures, which may be “Purchases of property, plant, and equipment” or anything to that effect under investing activities.
- Subtract CapEx from OCF to get your free cash flow.
This is the easiest way to calculate FCF, which finds regular use in analysis.
Why Investors and Analysts Love Free Cash Flow
Free cash flow can provide a very accurate picture of how well a company is doing at creating value for its shareholders. In most cases, it’s a better option than such traditional metrics as EBITDA or even net profit. Here are some reasons why free cash flow is so popular:
- Actual performance indicator: FCF reflects what actually happened in the firm’s cash account, not some kind of earnings. This means its way more difficult to manipulate with the use of dirty accounting tricks.
- Funds for growth: firms that have a high free cash flow can finance new projects or acquisitions without any outside financing.
- Investor rewards: when a company has some extra FCF, it can start paying dividends, buy back their shares, or reduce their debt.
Check out our expert guide: Cash Flow From Investing
Free Cash Flow vs. Other Metrics
It’s important to understand how free cash flow differs from similar terms:
| Metric | Description | Focus |
| Net Income | Revenue minus expenses, taxes, and interest | Accounting profit |
| EBITDA | Earnings before interest, taxes, depreciation, and amortisation | Operating efficiency |
| Operating Cash Flow | Cash from core operations | Liquidity from operations |
| Free Cash Flow | Operating cash minus capital expenditures | True available cash |
Net income and EBITDA can be useful, but they can’t tell you how much actual cash the company has at its disposal. That’s probably the greatest advantage of this term in the framework of a complete cash flow analysis.
Limitations of Free Cash Flow
Although powerful, FCF is not a fool-proof measure; it comes with a number of limitations:
- Volatility: FCF can vary significantly between years, especially for capital-intensive industries.
- Not always positive: A negative free cash flow is not always bad. Startups and growing concerns may decide to invest aggressively up front. In addition, free cash flow does not take into account the time value of money.
- CapEx judgment: Capital expenditure timing varies and does not always coincide with a business cycle, affecting cash flow accuracy.
Types of Free Cash Flow
There are a few variations on the free cash flow metric depending on the use case:
- Free Cash Flow to Firm (FCFF)
This measures cash available to all capital providers (debt and equity).
FCFF = EBIT × (1 – Tax Rate) + Depreciation – CapEx – Change in Working Capital
- Free Cash Flow to Equity (FCFE)
This represents cash available only to equity shareholders after accounting for debt.
FCFE = Net Income + Depreciation – CapEx – Change in Working Capital + Net Borrowing
These alternative versions of the FCF formula are used in valuation models, like the Discounted Cash Flow (DCF) method.
Conclusion
It is an essential concept to understand free cash flow whether you are an investor analysing stocks or a company officer guiding its growth. It often represents the best approximation of the company’s profit potential that can stand without heavy subjective adjustments.
By learning the FCF formula and its implementation, along with knowing how to calculate free cash flow from the cash flow statement, you get a very useful tool to assess a business. It runs cash flow analysis over operational efficiency, financial solvency, and shareholder value. Its role in the overall analysis of cash flow means it should be part of the toolkit of every person in finance.
From startups currently carrying negative FCF due to the growth they’re trying to seek, to even the largest companies with billions in free cash flow of multiples, being able to assess cash flows has historically been one of our most powerful indicators of a company’s health.
FAQs
What is free cash flow in simple terms?
Free cash flow or FCF measures how much cash a company has left after paying for operating expenses and accounting capital expenditures. It calculates the net cash generated by a company, which is available for business expansion, acquisitions, repurchasing stock and paying dividends, and other investment. It is also used to measure a company’s capacity to pay debts.
How do I compute free cash flow?
The formula is FCF = Operating Cash Flow – Capital Expenditures.
Alternatively, FCF = Net Income + Depreciation – Change in Working Capital – CapEx.
Why free cash flow is important for investors?
Investors use it to see whether a company has enough cash to reinvest in the business and still pay dividends or reduce debts without taking external financing.
Is high free cash flow always good?
High FCF is generally good. However, it may not always be so. A company may be underinvesting for fear that there may not be a payback on expansion or investment anymore.
What’s the difference between free cash flow and operating cash flow?
Operating cash flow reflects the cash generated by a company’s core operations. The free cash flow is the OCF less capital expenditures. In most cases, much of the OCF will be used to purchase or acquire or develop properties or equipment, and thus the free cash flow is calculated to show how much cash the company has in reserve or as excess for shareholders or rebate of debts.
