Free Cash Flow Defined & Calculated | The Motley Fool (2024)

Free cash flow (FCF) is the cash that remains after a company pays to support its operations and makes any capital expenditures (purchases of physical assets such as property and equipment). Free cash flow is related to, but not the same as, net income. Net income is commonly used to measure a company's profitability, while free cash flow provides better insight into both a company's business model and the organization's financial health.

Free Cash Flow Defined & Calculated | The Motley Fool (1)

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What is free cash flow?

What is free cash flow?

Free cash flow is calculated using several items from a company's cash flow statement. To determine FCF, subtract "capital expenditures" from "net cash from operating activities" (sometimes listed as "cash provided by operations" or a similar term). The formula looks like this:

  • Free cash flow = Net cash from operating activities - Capital expenditures

If a company (such as many high-growth technology companies) has "capitalized software expenses" or regularly reports "business acquisitions" on its cash flow statements, then these cash outlays are also subtracted from "net cash from operating activities" to calculate FCF.

To find these items in a company's quarterly or annual filing, look for the cash flow statement. This table is divided into three sections: Operating activities, investing activities, and financing activities. "Net cash from operating activities" (or something similar) can be found under the operating activities section, while "capital expenditures" and other qualifying expenses are listed under investing activities.

How to calculate FCF

How to calculate FCF

Here are two real-world FCF examples from two different companies, Chevron and Nike.

First, from Chevron's statement of cash flows from its 2022 annual report.

  • (Net cash provided by operating activities of $49.6 billion) - (Capital expenditures of $12 billion) = Free cash flow of $37.6 billion

And from Nike's 2022 annual report filing under the consolidated statement of cash flows:

  • (Cash provided by operations of $5.2 billion) - (Additions to property, plant, and equipment of $758 million) = Free cash flow of $4.4 billion.

As you can see, FCF is calculated for all types of companies. A company that requires heavy investment in property and equipment like Chevron can produce meaningful free cash flow. So can companies with lots of non-physical assets like branding and e-commerce sites such as Nike.

Whatever the company does for business, FCF is a simple measure of leftover cash at the end of a stated period of time. This remaining cash is available to the company for paying off debt, paying dividends to shareholders, or funding stock repurchase programs. (Such transactions are recorded in the "financing activities" section of the cash flow statement).

The free cash flow figure can also be used in a discounted cash flow model to estimate the future value of a company.

Definition Icon

Cash Flow

Cash flow is how we measure the actual money flowing through a business that can sometimes be hidden behind complexities.

How FCF differs from net income and EBITDA

How FCF differs from net income and EBITDA

Free cash flow is different from a company's net earnings or net loss, which are used to calculate the popular earnings per share (EPS) and price-to-earnings (P/E) ratios.

FCF excludes non-cash items like depreciation and amortization (assessed for only tax purposes to account for the values of assets paid for in the past), changes in inventory values, and stock-based employee compensation. Because FCF only encompasses cash transactions, it gives a clearer picture of just how profitable a company is.

FCF can also reveal whether a company is manipulating its earnings -- such as via the sale of assets (a non-operating line item) or by adjusting the value of its inventory of products for sale. Or, if a company made a large purchase (like buying a new property or investing in new intangible assets) in the recent past, then free cash flow could be higher than net income -- or still positive even when a company reports a net loss.

FCF is also different from earnings before interest, taxes, depreciation, and amortization (EBITDA). Unlike FCF, EBITDA excludes both interest payments on debt and tax payments. Like FCF, EBITDA can help to reveal a company's true cash-generating potential and can be useful to compare one firm's profit potential to its peers.

Definition Icon

Asset

An asset is a resource used to hold or create economic value.

FCF is important -- but still has limitations

FCF is important -- but still has limitations

FCF, as compared with net income, gives a more accurate picture of a firm's financial health and is more difficult to manipulate, but it isn't perfect. Because it measures cash remaining at the end of a stated period, it can be a much "lumpier" metric than net income.

For example, if a company purchases new property, FCF could be negative while net income remains positive. Likewise, FCF can remain positive while net income is far less or even negative. If a company receives a large one-time payment for services rendered, its FCF very likely may remain positive even if it incurs high amortization expenses (like the costs of software and other intangible assets for a cloud computing company).

Because of the short-term variability inherent in FCF, many investors opt to evaluate the health of a company using net income since it smooths out the peaks and valleys in profitability. However, when evaluated over long periods of time, FCF provides a better picture of a company's actual operational results. FCF is also useful for measuring a company's ability to pay down debt and fund dividend payments.

Negative FCF reported for an extended period of time could be a red flag for investors. Negative FCF drains cash and assets from a company's balance sheet, and, when a company is low on funds, it may need to cut or eliminate its dividend or raise more cash via the sale of new debt or stock.

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Use FCF as part of your stock selection process

Use FCF as part of your stock selection process

Free cash flow has its limitations, but it can also be a powerful tool. Consider it along with other metrics such as sales growth and the cash flow-to-debt ratio to fully assess whether a stock is worthy of your hard-earned money.

The Motley Fool has a disclosure policy.

Free Cash Flow Defined & Calculated | The Motley Fool (2024)

FAQs

Free Cash Flow Defined & Calculated | The Motley Fool? ›

To determine FCF, subtract "capital expenditures" from "net cash from operating activities" (sometimes listed as "cash provided by operations" or a similar term). The formula looks like this: Free cash flow = Net cash from operating activities - Capital expenditures.

What is free cash flow and how is it calculated? ›

The generic Free Cash Flow (FCF) Formula is equal to Cash from Operations minus Capital Expenditures. FCF represents the amount of cash generated by a business, after accounting for reinvestment in non-current capital assets by the company.

What is free cash flow for dummies? ›

You figure free cash flow by subtracting money spent for capital expenditures, which is money to purchase or improve assets, and money paid out in dividends from net cash provided by operating activities.

Why use FCFF vs FCFE? ›

FCFF is particularly important for creditors, as it is a measure of how much cash a company has available to service its debt obligations. FCFE is important for equity investors, as it is a measure of how much cash a company has available to return to its shareholders in the form of dividends or share buybacks.

What is the difference between FCF and FFO? ›

Funds from operations (FFO) to total debt ratio is a leverage ratio that a credit rating agency or investor uses to gauge a company's financial risk. Free cash flow (FCF) represents the cash a company can generate after accounting for capital expenditures needed to maintain or maximize its asset base.

How does Warren Buffett calculate free cash flow? ›

First, he studies what he refers to as "owner's earnings." This is essentially the cash flow available to shareholders, technically known as free cash flow-to-equity (FCFE). Buffett defines this metric as net income plus depreciation, minus any capital expenditures (CAPX) and working capital (W/C) costs.

What is a good FCF percentage? ›

A “good” free cash flow conversion rate would typically be consistently around or above 100%, as it indicates efficient working capital management. If the FCF conversion rate of a company is in excess of 100%, that implies operational efficiency.

Is free cash flow just profit? ›

Indication: Cash flow shows how much money moves in and out of your business, while profit illustrates how much money is left over after you've paid all your expenses.

What is free cash flow with example? ›

Free cash flow (FCF) is referred to the cash a company generates after considering the cash outflows to support its operations and maintain its capital assets. In simple words, FCF is the money left after paying for things such as payroll, taxes and a company can use it as per its wish.

Do dividends affect free cash flow? ›

Free Cash Flow and Dividends

Dividends are cash payments to investors as a reward for owning the stock. If a company is generating free cash flow that exceeds dividend payments, it's likely to be seen as favorable to investors, and it could mean that the company has enough cash to increase the dividend in the future.

Why is free cash flow more important than profit? ›

Cash flow statements, on the other hand, provide a more straightforward report of the cash available. In other words, a company can appear profitable “on paper” but not have enough actual cash to replenish its inventory or pay its immediate operating expenses such as lease and utilities.

How to get from Ebitda to free cash flow? ›

FCFF can also be calculated from EBIT or EBITDA: FCFF = EBIT(1 – Tax rate) + Dep – FCInv – WCInv. FCFF = EBITDA(1 – Tax rate) + Dep(Tax rate) – FCInv – WCInv. FCFE can then be found by using FCFE = FCFF – Int(1 – Tax rate) + Net borrowing.

Do you want a high or low FCF yield? ›

A higher free cash flow yield is better because then the company is generating more cash and has more money to pay out dividends, pay down debt, and re-invest into the company. A lower free cash flow yield is worse because that means there is less cash available.

Do you want a high or low FCF? ›

As such, in general, the higher the free cash flow yield, the better. A higher value signifies that you have more cash on hand to use after taking care of your obligations to keep operations running smoothly. On the contrary, a lower FCF yield would show that your capital is limited.

Why is FCF better than EBITDA? ›

FCF allows investors to assess whether a company has excess cash available for these purposes, whereas EBITDA does not provide this insight. FCF is often considered a more conservative and resilient measure of a company's financial health. It accounts for the sustainability of a company's cash generation over time.

What is free cash flow and why is it important? ›

The “free” in free cash flow means how much a business has in its coffers to spend. Considered a reliable measure of business performance, free cash flow provides a glimpse of how much cash your business really has to draw on. A healthy, positive free cash flow indicates the business has plenty of cash left over.

What is an example of FCF? ›

Free Cash Flow is calculated by taking cash flows from operating activity less both capital expenditures and debt payments. If cash flows from operating activities are $1,355, capital expenditures are $1000, and debt payments are $125, then FCF = $1355 - $1000 - $125 = $230.

What does price to free cash flow tell you? ›

Key Takeaways. Price to free cash flow is an equity valuation metric that indicates a company's ability to continue operating. It is calculated by dividing its market capitalization by free cash flow values.

What is the difference between cash flow and free cash flow? ›

Comparing Cash Flow vs. Free Cash Flow. Cash flow is seen as a straightforward measure of the net cash that came into or left the business during a given period of time. Free cash flow is a figure that tells investors how much cash your business has on hand after funding its operating and investing needs.

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