What is Free Cash Flow (FCF)?
Free cash flow (FCF) is the cash a company generates from operations after paying for the capital expenditures (CapEx) required to maintain or expand its asset base. In practical terms, FCF is the cash that’s available to repay creditors, pay dividends, buy back shares, or reinvest in the business.
Key takeaways
– FCF = Cash from operations − Capital expenditures (simple, commonly used definition).
– Variants exist: free cash flow to the firm (FCFF) and free cash flow to equity (FCFE); they differ in how interest, debt issuance, and tax are treated.
– Investors prefer FCF for assessing the quality of earnings, because it starts from actual cash rather than accrual accounting measures.
– FCF can be volatile because capital spending is lumpy and working capital swings can distort a single-period reading.
– Always analyze trends, normalize for one-time items, and compare FCF metrics to peers and the company’s historical patterns.
Core formulas
– Basic FCF (most common): FCF = Operating cash flow (CFO) − Capital expenditures (CapEx)
– Operating cash flow = Cash flows from operating activities (statement of cash flows)
– Free cash flow to the firm (FCFF):
FCFF = EBIT × (1 − Tax rate) + Depreciation & Amortization − Change in net working capital − CapEx
– Free cash flow to equity (FCFE):
FCFE = Net income + Depreciation & Amortization − Change in net working capital − CapEx + Net borrowing (debt issued − debt repaid)
Step-by-step: How to calculate FCF from financial statements
1. Gather statements: latest income statement, balance sheet, and statement of cash flows.
2. Determine operating cash flow (CFO): use “Net cash provided by operating activities” on the cash-flow statement. This already adjusts net income for non-cash items and working-capital changes.
3. Identify CapEx: find “Purchases of property, plant & equipment” (or similar) in investing activities on the statement of cash flows. Use only cash CapEx (exclude noncash additions).
4. Compute FCF: subtract CapEx from CFO.
– Example: CFO = $500,000; CapEx = $150,000 → FCF = $350,000.
5. For FCFF or FCFE, use the alternative formulas above if you need to adjust for interest and debt flows.
Practical numeric example (illustrative)
– EBITDA: $1,000,000
– Depreciation & amortization: $100,000
– Interest expense: $50,000
– Tax rate: 25%
– Change in net working capital: $0
– CapEx: $800,000
FCFF (via EBIT):
– EBIT = EBITDA − D&A = $900,000
– EBIT × (1 − T) = $900,000 × 0.75 = $675,000
– FCFF = $675,000 + $100,000 − $0 − $800,000 = $ −25,000
Basic FCF (CFO − CapEx) would require CFO; if CFO ≈ EBITDA − Taxes + working capital adjustments, a similar result can follow. This example shows how large CapEx can make FCF negative even with positive earnings.
Interpreting FCF: metrics and uses
– Trend analysis: Look at multi-year trends—rising FCF is generally positive; declining FCF may signal operational issues, rising inventories, or heavier CapEx.
– Per-share and margin metrics:
– FCF per share = FCF / Shares outstanding.
– FCF margin = FCF / Revenue (shows cash conversion efficiency).
– FCF yield = FCF / Market capitalization (cash-based analogue of earnings yield).
– Coverage and sustainability:
– Dividend coverage = FCF / Dividends paid (how sustainable dividends are).
– Debt coverage = FCF / Debt repayments or interest (ability to service debt).
– Valuation:
– Use FCFF for enterprise-value DCFs (discount FCFF at WACC).
– Use FCFE for equity-value DCFs (discount FCFE at cost of equity).
Adjustments and practical considerations
– Maintenance vs growth CapEx: Separate sustaining (maintenance) CapEx from growth CapEx when assessing sustainable FCF. Companies investing for growth may show low or negative FCF temporarily but still be valuable.
– Working capital swings: Increases in inventories or receivables reduce FCF today even if they support future sales. Investigate causes (seasonality, customer terms changes, poor collections).
– One-time items: Exclude unusual or nonrecurring cash flows (e.g., large asset sales, litigation settlements) when evaluating core FCF.
– Depreciation methods and tax rules: Depreciation does not equal cash spending. Tax timing and accelerated depreciation may make FCF and net income diverge.
– Operating leases and IFRS/ASC 842/IFRS 16: New lease accounting changes shift some previously off-balance-sheet commitments onto the balance sheet; these may affect CapEx-like assessments and FCF comparisons across time.
– Capitalizing vs expensing: Changes in accounting policy can affect reported CapEx and operating cash flow—restate where practical for comparability.
Limitations and red flags
– Lumpy CapEx: One large purchase can make FCF appear poor in the year of purchase even if the investment is value-accretive long term.
– Manipulation via working capital: Management might delay payables or accelerate receivables to temporarily inflate CFO and FCF.
– Low disclosure: FCF is a calculated measure, not a GAAP line item; calculate consistently and inspect the components.
– Negative FCF is not always bad: Fast-growing companies often have negative FCF because they invest heavily in expansion.
Practical steps for investors (checklist)
1. Calculate FCF for at least 3–5 years and look for trends and seasonality.
2. Compute FCF margin and FCF per share; compare to peers and historical average.
3. Separate maintenance CapEx from growth CapEx if possible.
4. Adjust for one-offs and normalize unusual items.
5. Check FCF coverage of dividends and interest payments.
6. Compare FCF yield to bond yields and competitors.
7. Investigate sudden changes in working capital (inventory spikes, slower collections).
8. Use FCFF in DCF valuations when assessing enterprise value; use FCFE for equity-value models if capital structure changes are fully modeled.
When to use FCFF vs FCFE
– Use FCFF when valuing the entire firm (discount at WACC) and when you want a capital-structure-neutral view.
– Use FCFE when you want the cash available to equity holders specifically (discount at cost of equity), and when debt issuance/repayment is modeled explicitly.
The bottom line
Free cash flow is a powerful, cash-based measure of corporate financial health that complements income-statement metrics. It helps investors gauge the company’s ability to generate cash for debt service, dividends, buybacks, and reinvestment. Because FCF is affected by CapEx timing and working-capital swings, it should be interpreted across multiple periods, normalized for one-time events, and compared with peers. Use FCF as one key input—along with profitability, growth prospects, and balance-sheet strength—when making investment decisions.
Source and further reading
– Investopedia — “Free Cash Flow (FCF)” (source material): https://www.investopedia.com/terms/f/freecashflow.asp
If you’d like, I can:
– Calculate FCF for a specific company from its financial statements step-by-step.
– Produce a one-page FCF analysis template (Excel-ready) you can use to screen stocks. Which would you prefer?