Free Cash Flow Formula: What it is and How to Calculate It

Free cash flow is the money available for distribution to owners or to be reinvested in your company. Free cash flow is also considered a measure of your company’s health. 

The formula for calculating free cash flow is straightforward and consists of two parts: operating cash flow and capital expenditures. The formula is as follows:

Free Cash Flow = Operating Cash Flow – Capital Expenditures

Let’s look at each of the components of the formula above. 

Operating cash flow.

Operating cash flow is the cash flow that comes from your company’s operations, which generate revenue, minus operating expenses. Note that this does not include investment income (Ex: dividends, interest, or capital gains) that your company receives. 

Operating expenses are any expenses that are incurred by creating revenue. Operating expenses can be fixed expenses or variable expenses and will vary based on your operation and industry. They often include rent, salaries, supplies, utilities, insurance, professional fees, and taxes, along with numerous other expenses. 

Operating cash flow is calculated using the following formula:

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

Net income is the company’s total revenue minus all of its expenses, including depreciation and amortization. Non-cash expenses are expenses that do not require cash payments, such as depreciation and amortization. Because the free cash flow formula is focused on the movement of cash, non-cash expenses are added back, since they do not affect cash flow. Changes in working capital include changes in current assets and current liabilities (Ex: accounts receivable, accounts payable, and inventory).

Operating cash flow shows whether or not the company is generating enough revenue to pay its expenses. Operating cash flow is an important metric for lenders and investors who are concerned with ensuring the ongoing operation of the company.

Capital expenditures.

Capital expenditures are expenses incurred by a company to acquire, upgrade, or maintain physical assets. Physical assets must be large (Ex: property, plant, and equipment). Smaller expenses (Ex: computers) would not usually be considered capital expenditure, since they are often expensed when purchased. Capital expenditures are typically large, one-time investments that benefit the company over several years. Capital expenditures include building a new manufacturing facility, purchasing new equipment, or upgrading technology.

Investors look at capital expenditures to measure a company’s investment in its future growth. While capital expenditures may reduce cash in the short term (if paid for in cash), they are necessary for a company to remain competitive and expand its operations. Lenders and investors often view capital investments as a positive sign that the company is planning for future growth.

By combining operating cash flow and capital expenditures, the free cash flow formula gives investors a view of a company’s financial health. A positive free cash flow indicates that the company is generating enough cash to cover its expenses and invest in its future growth, while a negative free cash flow suggests that the company is struggling to generate cash and may need to take steps to improve its financial position.

Importance of free cash flow formula.

The free cash flow formula can provide valuable insight for investors, lenders, and business owners. Each of the parties has a similar goal of determining if the company is able to generate enough cash to run its operations while also investing in its future. 

Positive free cash flow indicates that a company has generated more cash than it has spent, allowing it to invest in growth opportunities, pay dividends to shareholders, and pay off debts. On the other hand, negative free cash flow indicates that a company is not generating enough cash to cover its expenses, which may result in cash flow problems, reduced investment, and a decreased ability to pay off debts.

Free cash flow will vary greatly by industry, but comparing the free cash flow of companies within the same industry can provide insights into which companies are generating the most cash and have the strongest financial positions. Companies with higher free cash flow are generally better positioned to invest in growth opportunities, pay dividends, and pay off debts.

Free cash flow can also be used to estimate a company’s ability to pay dividends and debts. Positive free cash flow provides a company with the necessary cash to pay dividends to shareholders and reduce its debt load. On the other hand, negative free cash flow can hinder a company’s ability to pay dividends and increase its debt load, potentially leading to financial instability.

The free cash flow formula can be used to value a company’s stock by estimating the present value of future free cash flow. This is achieved by projecting a company’s expected free cash flow over a certain period and discounting it back to its present value. This valuation method provides investors with a better understanding of a company’s intrinsic value and helps them make informed investment decisions.

Limitations of the free cash flow formula.

Though the free cash flow formula is an important tool, it’s not without its drawbacks. 

The free cash flow formula relies on estimates and assumptions, which may not always be accurate. These estimates may be affected by changes in market conditions, economic factors, and other external factors, which can impact the accuracy of the free cash flow calculation.

The free cash flow formula does not take into account non-cash expenses and revenues (Ex: depreciation and amortization) which can impact a company’s financial position. These non-cash items can affect a company’s profitability, and failing to include them in the calculation can result in an incomplete picture of the company’s financial health.

The free cash flow formula is based on historical data and may not reflect short-term changes in a company’s cash flow. For example, a company may experience a temporary increase in its accounts receivable, resulting in a decrease in free cash flow in the short term, even though the company’s long-term financial position remains strong. Similarly, a company may have a temporary increase in its accounts payable, resulting in an increase in free cash flow in the short term, even though it may have longer-term financial obligations that need to be met.

Free cash flow is difficult to use when comparing opportunities in different industries. Some industries require large capital expenses, while others may have large overhead expenses. Because of these variations, other financial ratios should be used when comparing different industries. 

Final thoughts

The free cash flow formula is an essential tool for evaluating a company’s financial health and investment potential. The formula can be used by business owners to look at their own company’s financial health, and it can be used by lenders to determine whether a loan should be made. 

Positive free cash flow indicates that a company has generated more cash than it has spent, allowing it to invest in growth opportunities, pay dividends to shareholders, and pay off debts. On the other hand, negative free cash flow indicates that a company is not generating enough cash to cover its expenses, which may result in cash flow problems, reduced investment, and a decreased ability to pay off debts.

While the free cash flow formula is a useful tool, it is important to recognize its limitations. The formula relies on estimates and assumptions, which may not always be accurate, and it ignores non-cash expenses and revenues that can impact a company’s financial position. Additionally, the formula may not reflect short-term changes in a company’s cash flow, which can impact the accuracy of the calculation.

To overcome these limitations, it is important to consider other financial metrics and ratios in addition to free cash flow. These can include measures such as earnings per share, return on investment, and debt-to-equity ratio, among others. By considering multiple metrics, investors and analysts can gain a more comprehensive understanding of a company’s financial position and make more informed investment decisions.

_{Information provided on this blog is for educational purposes only, and is not intended to be business, legal, tax, or accounting advice. The views and opinions expressed in this blog are those of the authors and do not necessarily reflect the official policy or position of Lendio. While Lendio strives to keep its content up-to-date, it is only accurate as of the date posted. Offers or trends may expire, or may no longer be relevant.}