Free Cash Flow Defined

Any company that wants to fund growth must generate more cash than just what it needs to meet day-to-day operating expenses. Public companies might pay shareholder dividends, while private businesses may use free cash to add product lines or make an acquisition.

How can you measure whether your company is generating the cash it needs to invest in its future? Enter free cash flow, a key financial metric.

What Is Free Cash Flow (FCF)?

Free cash flow (FCF) is the money a company has left from revenue after paying all its financial obligations—defined as operating expenses plus capital expenditures—during a specific period, such as a fiscal quarter. FCF is the cash a company is free to use for discretionary spending, such as investing in business expansion or building financial reserves.

Operating Cash Flow vs Free Cash Flow

Operating cash flow and free cash flow are both important measures of a business’ financial health, but have key differences.

Operating cash flow is the net cash inflows and outflows during an accounting period—in other words, all the revenue coming in minus all the expenses paid out. It can be found on a company’s cash flow statement, where it’s sometimes listed as “cash flow from operating activities” or “net cash generated from operations.” Operating cash flow is a standard metric under U.S. Generally Accepted Accounting Principles, a set of rules issued by the Financial Accounting Standards Board (FASB).

However, operating cash flow has limitations as a metric because it doesn’t include the cost of acquiring and maintaining fixed assets or the effect of changes in working capital, which often signal that a business is struggling. Free cash flow takes these factors into account, and therefore can provide a better picture of a company’s ability to generate the cash it needs to grow and pay creditors and investors.

Video: What Is Free Cash Flow?

Key Takeaways:

• Because cash is top priority in a business—both to meet operating expenses and invest in the future—free cash flow can reveal important insights into the health of any company.
• The basic free cash flow formula is simple: operating cash flow minus capital expense. It’s what you have left after paying operating and capital costs.
• Levered free cash flow reveals how much cash a business generates after accounting for debt.
• Unlevered free cash flow is a hypothetical measure showing how much free cash the business would generate if it had no debt. It can be used to estimate a company’s enterprise value.
• Sustained positive free cash flow can help a company get better terms when borrowing for expansion. But by itself, free cash flow can be misleading. It’s volatile by nature so it should be analyzed over several periods and viewed in conjunction with other metrics.

Why is Free Cash Flow Important?

In business, profits are important but cash is singularly vital. Companies need cash to pay their operating expenses and other immediate financial obligations. But they also need cash to develop new products, expand operations and make acquisitions—the activities by which companies live and die over the long term. That’s why FCF is such a crucial measure of a business’ health.

FCF metrics are invaluable for business managers, creditors and investors:

• Business managers use FCF to monitor performance and inform plans for future expansion.
• Creditors use FCF to help determine how much debt a company can support.
• Investors use a variation—levered free cash flow, also called free cash flow to equity (FCFE )—to indicate how much cash could potentially be redistributed to shareholders in the form of dividends.

Companies that don’t have much cash left over after all the bills are paid often find it difficult to borrow or attract investors.

Types of Free Cash Flow

There are three main types of free cash flow metrics. They differ primarily based on how each metric treats debt. Still, all three views of free cash flow represented by the FCF metrics can offer insights into the business that are valuable to different stakeholders.

The basic FCF formula—operating cash flow minus capital expense—tells you the amount of money left over after the business has met all its obligations, from both the operating and capital perspectives, in that period. While FCF includes interest expense for the period, it does not include new debt that the company may take on or account for debt that it pays off.

Therefore, for example, it’s possible for FCF to look misleadingly positive if viewed by itself for a period in which the company took on more debt, which would appear as a boost to cash flow.

Levered free cash flow, also known as free cash flow to equity (FCFE), differs from FCF because it includes changes in net debt—any new debt that the company incurs or loan balances that it pays off. The resulting number represents the cash flow available to investors, who often mean “FCFE” even though they may refer simply to “free cash flow” or even just “cash flow.”

FCFE is most frequently used in financial analysis to determine a firm’s equity value.

Unlevered free cash flow, also known as free cash flow to the firm (FCFF), is a hypothetical figure used to estimate what a firm’s cash flow would look like if it had no debt. Therefore, FCFF strips out the effect on cash flow of a company’s debt liabilities, giving a better idea of the underlying business’ real ability to generate cash. Firms that carry significant debt often report unlevered free cash flow. FCFF projections are used in financial modeling as a way to calculate enterprise value.

How to Calculate Free Cash Flow

Baseline FCF is calculated by subtracting capital expenditure from the company’s cash flow from operations. Both figures appear in the company’s cash flow statement. If the company doesn’t produce a cash flow statement, FCF can also be calculated from current and previous income statements and balance sheets.

FCFE can be calculated by deducting net debt issuance from FCF or adding net debt repayment back to it. In other words, if a company issues a $100 million bond during the period in question and pays off a $50 million loan, it had net debt issuance of $50 million. That amount must be deducted from FCF to arrive at FCFE. In periods during which there is net debt repayment, the amount would be added to FCF to obtain FCFE.

When it comes to the hypothetical FCFF, there are multiple ways to calculate it, all involving data from a company’s income and cash flow statements along with information about tax rates. But they all share a common goal: Strip away the effects of a business’ capital structure to reveal its inherent FCF potential.

What Is the Free Cash Flow Formula?

Naturally, the three free cash flow calculations have different formulas. Let’s walk through each, then illustrate them with examples.

The basic formula for FCF is:

FCF = Operating cash flow – capital expenditure

This can be extended to get the formula for FCFE, thus:

FCFE = FCF – net debt issuance

Or, for added clarity:

FCFE = Operating cash flow – capital expenditure – (debt issued – debt repaid)

The formula for calculating FCFF, however, is not a simple extension of these. In fact, it’s an entirely different ballgame. At the highest level, it can be expressed as:

FCFF = Unlevered operating cash flow – capital expenditure

The trick, though, is getting at unlevered operating cash flow. That requires multiple steps, each with its own formula. To aid understanding, we’ve explained those in the examples section, next.

Examples of Free Cash Flow

To illustrate calculations of the three free cash flow formulas, we’ve presented simplified excerpts of real-life cash flow and income statements from a typical small manufacturing company. Let’s call it Michigan Widgets.

Note that operating cash flow—labeled “Net cash provided by operating activities” in Michigan Widget’s cash flow statement—starts with net income, then adds depreciation and amortization expenses as well as changes in accounts receivable, inventory and accounts payable. Capital expense is found on the “Additions to property, plant and equipment” line.

If we use those numbers in the baseline FCF formula (FCF = Operating Cash Flow – Capital Expenditure) we get:

FCF = $2,552,000 – $1,374,000, or $1,178,000

To derive FCFE, we simply subtract net debt issuance, found in Michigan Widget’s cash flow statement under “Cash flows from financing activities.”

FCFE = $1,178,000 - $2,367,000, or ($1,189,000)

As you can see, this is a case where FCFE reveals that the period’s FCF has been inflated by net debt issuance.

Calculating FCFF is more complex. Because the goal is to strip out the effect of debt—in other words, to unlever the business’ cash flow—FCFF calculations look like this:

• Start by determining unlevered net income.
• Use that figure to calculate unlevered operating cash flow.
• And, finally, substitute the hypothetical unlevered operating cash flow number for operating cash flow in the baseline FCF formula.

The steps for a typical FCFF formula are as follows.

1. Calculate the company’s unlevered net income: Start by calculating earnings before interest and taxes (EBIT) from Michigan Widgets’ income statement. To do this, take net income ($424,000) and add back interest expense ($550,000) and taxes paid ($0); EBIT equals $974,000. Using information on tax rates, calculate the tax that the company would have paid if there were no interest expense. Since interest on debt is tax deductible for a business (known as the “tax shield on debt”), this will be higher than the actual tax paid. For the purposes of this exercise, assume taxes are 10% of EBIT. Deduct this hypothetical tax amount from EBIT to give the unlevered net income figure:

   Unlevered Net Income = $974,000 – $97,400, or $876,600

2. Calculate the company’s unlevered operating cash flow: Take the top half of Michigan Widgets’ cash flow statement, substitute unlevered net income ($876,000) for net income, and recalculate operating cash flow. Do this by adding back depreciation and amortization and any increase in non-cash working capital, such as accounts payable, accounts receivable and inventory. Of course, if there was a decrease in noncash working capital, you’d deduct it.

   Excerpted Top of Michigan Widgets Cash Flow Statement
   Cash flows from operating activities
   Unlevered net income	877
   Adjustments to reconcile net income to net cash provided by operating activities:
   Depreciation and amortization	1,927
   Change in accounts receivable	163
   Changes in inventory	63
   Changes in accounts payable	(25)
   Unlevered net cash provided by operating activities	3,005

3. Finally, use the FCF formula to calculate FCFF: Remember, the baseline FCF formula is operating cash flow—which now, unlevered, is $3,005,000—minus capital expense, or $1,374,000, from the original cash flow statement. So:

   FCFF = $3,005,000 – $1,374,000, or $1,631,000

Benefits of Free Cash Flow

A good FCF can enable companies to borrow for expansion, since it reassures lenders that the company is capable of generating the cash it needs to service additional debt. And, as already discussed, FCF is a key measure of business performance and potential that tells leadership how much they have available to invest in new projects, acquire a business or redistribute to shareholders.

Further, FCF informs investors about the likely future performance of a company. A firm that is generating significant positive FCF year-on-year is often a good investment prospect. However, companies that have negative FCF can also be smart investments, if the reason for the negative FCF is that the company is investing heavily in, say, plant and machinery that’s expected to deliver a good return in the future.

Limitations of Free Cash Flow

The principal limitation of FCF is that it applies the entire cost of capital expenditure in the period in which the property or equipment was acquired, rather than spreading it over several periods as the main financial statements do. As a result, FCF can give a misleading impression of a company’s cash position, understating it in the period when a capital acquisition is made and overstating it in subsequent periods.

Additionally, when there are repeated capital expenditures over a number of reporting periods, year-on-year FCF can be much more volatile than net income or operating cash flow.

When a capital expenditure is debt-financed, FCFE can be particularly misleading because it applies the cost of the capital acquisition plus the debt issued to finance it in the same period. The example above shows how a significant debt-financed capital expenditure can make FCFE turn sharply negative. In some industries, such as oil and mining, large capital asset bases financed with debt are normal. For companies in these industries, sudden sharply negative FCFE is not necessarily a matter for concern.

FCFF can be a helpful metric for companies in industries where high leverage is normal. However, by itself, it can give a misleading impression of solvency. Positive FCFF does not indicate that a highly leveraged company would survive a business interruption or economic downturn. In fact, because it excludes debt service costs, positive FCFF may not even mean the company can afford its present level of debt.

The Bottom Line on Free Cash Flow

Free cash flow metrics are invaluable for business managers, investors and creditors. Business managers use FCF to monitor business performance and inform plans for future expansion. Investors use FCFE to measure the cash generation capability of the company and indicate how much cash could potentially be redistributed to shareholders. Financial analysts use FCFE and FCFF in discounted cash flow models that calculate, respectively, the equity and enterprise values of a company. Creditors use FCF to help them determine the level of borrowing that a company can support.

However, FCF metrics by themselves do not give a complete picture of a business’ financial health. They should always be considered in light of what is normal for the industry and in conjunction with the main financial statements and other metrics. And because FCF is by nature volatile, it should also be viewed over multiple reporting periods.