What Is Free Cash Flow (FCF), And How Do You Calculate It?

What is free cash flow?

Free cash flow is money left after accounting for all cash payments towards operating expenses, inventory, and capital expenditures or CapEx (funds spent on buying or upgrading fixed assets such as property and equipment). As free cash flow is cash that remains after all internal and external financial obligations have been met, it represents funds that can either be invested back in the business or distributed to shareholders through paying dividends, or used for other financial strategies.

Investors are keenly interested in free cash flow as it stands for what they value most – cash that's free to be used at the company’s discretion. By studying a company’s FCF over time, they get to know if it can pay dividends to shareholders in the future. They also get a sense of the company's ability to pay back debts and raise new funds, crucial factors in any investment decision.

Calculating and analysing free cash flow also benefits businesses. They gain a better understanding of their ability to generate cash, which helps them make wise investment choices and manage their cash flow efficiently. Using insights provided by FCF, business leaders can safely pursue ventures that promise a handsome return on investment for the company and its investors. Monitoring FCF trends from year to year is good practice as the changes inform you of how your key operations are functioning.

Why free cash flow matters

How do you calculate FCF?

The formula to calculate free cash flow is:

Free cash flow = Operating cash flow – Capital Expenditures

• Operating cash flow is cash generated by a business from its primary, revenue-producing operations. It is the very first section on the cash flow statement.
• Capital expenditures (CapEx) is also derived from the cash flow statement's ‘cash flow from investing activities’ section.

However, if you don’t have access to a cash flow statement, you can use an alternative FCF formula that breaks down the simplified formula from above and uses data from the income statement and balance sheet. This free cash flow formula is:

Free cash flow = Net Income + Non-cash expenses – Changes in non-cash working capital – Capital expenditures

• Net income, non-cash expenses, and changes in non-cash working capital are components of the overall cash flows, with net income being the profit a business is left with after deducting all expenses. It is the last line of the income statement, hence also called the bottomline.
• Non-cash expenses include depreciation, amortisation, stock-based compensation (payment in the form of equity instead of cash), gains and losses on investments, and so on. Non-cash expenses can also be computed from the income statement.
• Changes in non-cash working capital are the difference between non-cash current assets (accounts receivable, inventory) and current liabilities (accounts payable). It can be calculated using balance sheet data.
• In the absence of a cash flow statement, the capital expenditures figure can be computed from the income statement and balance sheet using the formula 'CapEx = Year 2 PP&E – Year 1 PP&E + Depreciation. (PP&E stands for plant, property and equipment, Year 2 for the current accounting period, and Year 1 for the prior accounting period.)

FCF formula components and where to find them

Example of a free cash flow calculation

Using data from this cash flow statement, let's calculate free cash flow:

Free cash flow = Net Income + Non-cash expenses (depreciation) – Changes in non-cash working capital (cash additions/deductions under cash flow from operating activities) – Capital expenditures (equipment purchase)

Free cash flow = SGD 60,000 + 5,000 – 29,000 – 23,000

Free cash flow = SGD 13,000

Now, let’s calculate using the simpler FCF formula: 

Free cash flow = Operating cash flow – Capital expenditures

Free cash flow = SGD 36,000 - 23,000

Free cash flow = SGD 13,000

Other types of free cash flow

Apart from the generic free cash flow, there are two other FCF-based metrics to acquaint yourselves with:  

Free cash flow to equity (FCFE)

Free cash flow to equity (FCFE) is cash that remains after deducting operational expenses, re-investments and debts. It is different from free cash flow as it accounts for a company’s debt financing obligations, such as principal loan repayments, interest expenses, and tax shield (savings on account of interest being tax-deductible). Since it brings debt financing into the mix, free cash flow to equity is commonly referred to as levered free cash flow.

The formula for free cash flow to equity is:      

Free cash flow to equity = Operating cash flow – Capital expenditures + Net debt issued

Free cash flow to equity represents cash available for distribution to shareholders (as dividends, share buybacks, etc) because all non-equity obligations have been met.

The FCFE metric matters to investors as it tells them if a company has available funds to pay cash dividends, buy back shares, or re-invest in the business, actions that are all beneficial to equity holders. Investors and analysts might also monitor FCFE to see if it matches dividend payments. If FCFE is lower than the payouts to shareholders, it indicates the use of debt to fund dividends. Most investors prefer such payments to come solely from a company’s free cash flow to equity.

Free cash flow to firm (FCFF)

Free cash flow to firm (FCFF) is cash a company is left with after accounting for all recurring operating expenses and re-investments but excluding debt payments. It represents money that is potentially available to investors (stockholders, bondholders, etc) and creditors. As it is independent of debt financing and its elements, free cash flow to firm is also called unlevered free cash flow.

The FCFF formula is:

Free cash flow to firm = NI + NC + (I x (1 – TR)) – LI – IWC

Here, NI is short for net income, NC for non-cash charges, I for interest, TR for tax rate, LI for long-term investments, and IWC for investments in working capital.

Several variations of this FCFF formula are also available and widely used, such as:

Free cash flow to firm = NOPAT + D&A – CapEx – Changes in NWC

Here, NOPAT is short for net operating profit after taxes, D&A for depreciation and amortisation, CapEx for capital expenditure, and NWC for net working capital. To use this FCFF formula, you’ll need to calculate NOPAT, the formula for which is 'NOPAT = EBIT × (1 – TR). (EBIT is for earnings before interest and taxes.)

Analysts use free cash flow to evaluate a company based on its cash generation. For the very same reason, FCFF measures business performance as well. And, as with all free cash flow metrics, FCFF is taken as a reliable indicator of the ability to pay dividends.

What does positive free cash flow mean?

If a company has positive free cash flow, it has sufficient cash left over, which it can re-invest or pay its shareholders. While positive free cash flow signals good financial health, it’s important to know its context. That’s because positive FCF can be due to factors unrelated to operational excellence. Asset sales, workforce downsizing, curtailing of expenses, and delays in accounts payable can all cause a surge in free cash flow that has nothing to do with the company performing well. It's not enough for free cash flow to remain positive. It should also grow over time.

What does negative free cash flow mean?

Negative free cash flow implies a business isn’t producing enough cash to pay for its operations or support its growth. But despite the pessimistic ring, negative FCF might not necessarily be a bad thing. A company that’s starting out or growing rapidly will likely have diminished free cash flow due to large inventory and working capital needs. What’s important is to monitor FCF over time and ensure it doesn’t remain negative for long, as this might indicate poor cash management.         

If FCF is falling, what does it mean?

Profitable companies can have negative free cash flow from time to time, primarily due to large investments with an eye on future profits. It’s okay as long as the cash crunch isn’t long-term or chronic enough to impact operations. But a consistently falling FCF is cause for concern. You’ll need to look into it, identify the problem areas, and fix them. Are your customers consistently late in making payments? Are your overhead expenses draining you? Do you have too much inventory lying idle? The reasons for falling free cash flow are many.

Fortunately, there are solutions, such as incentivising customers to pay early by offering discounts. Or, cutting back on expensive overheads (rent, utility, etc) but only to the extent where they don’t affect operations. Stock only inventory that sells and get rid of the rest at a discount. Restructure your debt and negotiate better payment terms with suppliers. If the situation is dire, you might even have to take aggressive action, such as restructuring your business operations.

What is considered a good FCF?

A business with enough cash to cover its costs and bills for a month is said to have good free cash flow, according to some analysts. Then there’s the ‘Rule of 40’ metric, which says a good FCF for SaaS companies is when their growth rate and free cash flow rate combined equals 40% or higher. Obviously, there is no standard answer to what constitutes a good FCF. What entrepreneurs can do is analyse FCF data diligently, monitoring trends over time instead of relying on absolute numbers. Free cash flow analysis can help you identify areas where performance is strong or weak. Analysing free cash flow also aids potential investors. For example, an investor is looking at a company's FCF tends and sees they were largely stable over the past five years. From this insight, the investor might then infer that the company’s shares will continue to rise without much risk of disruption.

Advantages of FCF

• Free cash flow (which uses cash basis accounting) is often preferred to net income (accrual accounting) as a measure of a company’s ability to generate cash. It presents a more accurate picture of a company’s cash situation.
• Free cash flow is a factor in company valuation as it provides insights into financial health and growth potential. The FCF metric also measures potential to generate returns on investment, raising its profile among investors and analysts.
• Free cash flow can be used to compare businesses as it focuses purely on cash generation.
• Debt financing is vital in running a business and creditors rely on FCF data to assess a company’s ability to generate cash and fulfil its financial obligations, including paying back its debts.  

Limitations of FCF

• Free cash flow considers investments in property, plant, and equipment (PP&E) for the purpose of calculating capital expenditures. Such one-time investments can distort FCF figures, making analysis a challenge.
• Different companies have different accounting practices, which impact their free cash flow calculations. This creates difficulties in comparing companies.
• Comparisons across industries using FCF should also be done carefully as figures can vary due to the nature of the business. For example, healthcare providers, law firms, accountancy service providers, and SaaS firms typically have high free cash flow due to low overhead expenses and reliable cash inflow. In contrast, restaurants, hotels, real estate firms, and seasonal businesses (ski resorts) often struggle with free cash flow on account of inconsistent sales and significant capital investments.   
• Cash flow can be manipulated, even if it is less easy to fudge than net income. For example, some businesses might display more free cash flow by delaying payments to suppliers or cutting back the time to collect on sales made on credit.
• It isn’t reliable to estimate free cash flow levels in the future based on current figures as capital expenditures can vary from year to year.
• As a financial metric, free cash flow is more prevalent among larger, established enterprises than among small businesses.

Frequently asked questions

Free cash flow vs cash flow

Cash flow is the inflow and outflow of cash to and from a business. Free cash flow is cash that remains after taking care of operating expenses and capital expenditures. Cash flow is a wider concept that mostly measures a company’s liquidity while FCF represents cash that is potentially available for distribution to shareholders. Cash flow accounts for cash from operating, investing, and financing activities. But free cash flow only considers operating cash flow. For more clarity, here’s an example: a company is attracting potential investors due to its enviable cash balance. In contrast, its free cash flow is much lower. After careful analysis, the investors attribute the healthy cash flow to a sizeable loan the company has taken out. What this tells us is that free cash flow gives a more precise reading of cash-generating ability and financial health as it focuses on cash flow from operations alone.

Free cash flow vs net income

Net income is revenue minus expenses and represents the profit made in a given period. It is based in accrual accounting, which puts it at variance with cash accounting-based free cash flow. The difference in accounting principles means that some of the items that make up the total net income might not have actually generated cash during the accounting period – for example, sales on credit that have been listed as income but for which payments are yet to come in. While FCF represents real cash generated, net income is an accounting metric and not a stand-in for a company’s real profit.

Levered free cash flow vs unlevered free cash flow

Levered free cash flow is also called free cash flow to equity (FCFE) while unlevered free cash flow is referred to as free cash flow to firm (FCFF). The main difference between the two is that levered free cash flow accounts for the impact of debt financing (repayments, interest payments), which unlevered free cash flow does not. Levered free cash flow is used to measure a company’s equity value (net asset value that is left for shareholders after payment of debts) while unlevered free cash flow measures enterprise value (total asset value excluding cash).

What is free cash flow yield?

Free cash flow yield is free cash flow divided by market capitalisation (a company’s stock market value). The formula to calculate it is: 

Free Cash Flow Yield = Free Cash Flow / Market Cap

Free cash flow yield is an important investment metric as it shows investors how well a business takes care of its financial obligations, especially dividend payouts to shareholders. The higher the free cash flow yield, the better it is. A low free cash flow yield suggests investors aren’t getting the returns they might have expected.

Cash flow optimisation with Aspire

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