What Is the Formula for Calculating Free Cash Flow and Why Is It Important?

Free cash flow (FCF) is the amount of cash a business has leftover after paying for all of its expenses, showing its ability to generate cash beyond its operational needs. This determines whether a business can expand, pay dividends, pay down debt, and survive economic downturns. FCF also helps investors and analysts gauge profitability, efficiency, and long-term prospects.

What Is Free Cash Flow?

Free cash flow is how much cash a company has after paying all cash outflows related to operating the business and maintaining capital assets. Businesses incur expenses just for operating, including rent, salaries, office supplies, utilities, insurance premiums, and so on. They also have capital expenditures, such as needing to buy new equipment.

The cash left after covering all of these expenses is free cash flow. A positive cash flow shows a business earns more than it spends while a negative FCF shows a business spends more than it earns.

With all the expenses paid for, a positive FCF means businesses can use this “extra” cash to invest back in the business, pay dividends to shareholders, or pay back creditors to manage their debt better.

Calculating Free Cash Flow

There are two primary ways of calculating free cash flow: (1) using operating cash flow and (2) using net income.

Using Operating Cash Flow

Calculating free cash flow from operating cash flow involves subtracting capital expenditures from operating cash flow. Operating cash flow is part of a company’s cash flow statement and details the cash generated from a business’s core operations. Capital expenditure is the money a business spends on machinery, equipment, and infrastructure.

The formula is:

Free Cash Flow = Operating Cash Flow – Capital Expenditures

Operating cash flow and capital expenditures can be found on the cash flow statement of a company.

For example, say a company had an operating cash flow of $250,000 and capital expenditures of $100,000. The company would have a free cash flow of $150,000.

FCF = 250,000 – 100,000 = 150,000.

This $150,000 could be used to invest back in the business, pay dividends to shareholders, or pay down outstanding debt.

Using Net Income

Calculating free cash flow from net income involves adjusting for non-cash expenses and working capital changes.

The formula is:

Free Cash Flow = Net Income + Non-Cash Expenses – Changes in Working Capital – Capital Expenditures

Non-cash expenses are depreciation and amortization, which reduce net income but do not impact cash flow. Working capital adjustments take into consideration changes in accounts receivable, inventory, and accounts payable.

For example, assume a company had net income for the period of $200,000, depreciation and amortization of $25,000, working capital changes of -$25,000, and capital expenditures of $100,000. Its free cash flow would be $150,000.

FCF = 200,000 + 25,000 – (-25,000) – 100,000 = 150,000

Both methods of calculating free cash flow result in the same number.

Importance of Free Cash Flow

As noted, free cash flow is one of the most important indicators of a company’s health. FCF tells you exactly how much cash a company generates, unlike earnings, which can be altered depending on accounting rules and non-cash items.

As with personal finances, free cash flow means more financial freedom and flexibility for a company. A company with a positive FCF can invest in new ventures, acquire other companies, expand its operations, or improve the quality of its core offerings.

It can also help carry a company through tough markets without having to rely on debt financing, which can cause a strain on company finances.

FCF is an important number for investors. Companies with high FCFs can return value to shareholders via dividends or stock buybacks. Low or declining FCF indicates the opposite; financial struggles.

Analysts also pay close attention to FCF for valuation modeling. The metric is used in discounted cash flow (DCF) models to determine the intrinsic value of a company, shedding more light than net income on the worth of a company because it shows actual available cash.

What Free Cash Flow Can Tell You

While a positive free cash flow underscores financial health, with the ability to pay dividends or expand the business, a negative free cash flow doesn’t always signal a company in trouble.

Startups or high-growth companies often spend heavily on product development, marketing, hiring, and building out operations before generating revenue. Startups are often spending much more cash than they are bringing in.

Profitability is often not the primary focus for these new companies; however, constant negative free cash flow without a clear strategy for profitability could be risky.

So while positive FCF indicates a financially healthy and stable company, investors need to understand why a company might have negative FCF. For example, a new company with a negative FCF might be healthier than a mature company with a negative FCF.

A consistently declining FCF may also spell trouble for a company. It could mean decreased profitability, reduced demand, rising costs, or other adverse factors. As with all financial analysis, you need to look at multiple indicators to gauge the true health of a company.

The Bottom Line

Free cash flow is a key financial metric that shows how much cash a company has left over after paying all of its expenses. A positive FCF gives a company flexibility, allowing it to invest in growth, return value to shareholders, or manage debt.

A negative FCF could indicate financial difficulty; however, the context must be understood, as some companies, like startups, are focused on expansion and growth. Investors and analysts rely on FCF to understand financial stability and future prospects, as it provides a clearer picture of financial health than earnings alone.