What is free cash flow?
Free cash flow can be defined as the cash generated by a company after it has taken care of the expenses that maintain the company’s capital asset and cover the company’s operations. In order words, it is the cash left over after a company foots its operating expenses and capital expenditures (CapEx).
The free cash flow is used by investors to evaluate the financial status of a company. Free cash flow (FCF) is one of the many financial metrics used by investors to evaluate a company’s health. Apart from FCF, investors use other metrics such as return on investment (ROI), earnings per share (EPS), the quick ratio, and the debt-to-equity ratio to analyze the health of a company.
The FCF calculation takes account of the amount of cash left after operating expenses and capital expenditures have been accounted for. After a company pays for things like rent, payroll, taxes, etc, the money that remains is the free cash flow which can be used as the company pleases.
It is assumed that the higher the free cash flow of a company the healthier the financial status of the company. This can be an indication that the company is capable enough to pay dividends, pay down debt, and contribute to growth. The essence of analyzing and knowing how to calculate free cash flow helps with cash management in the company. The calculation for free cash flow can also give investors an insight into the financial health of a company, thus, helping investors make better investment decisions.
This metric is important because it helps to show the efficiency of a company in generating cash. Hence, investors use FCF to gauge whether a company might have enough cash for share buybacks or dividends. It is assumed that the more free cash flow a company has, the better. This is because the company is in a better position to pay down debt and pursue opportunities that can grow its business. Therefore, making the company attractive to investors.
FCF valuation and interpretation
FCF valuation can tell you a lot about the health of the business. This is because having enough amount of free cash flow tells that the business has enough money to pay bills and still has a substantial amount that has been left over to be used in several ways, including distribution to investors.
The FCF valuation shows how much cash has been left over in a company after paying its operating expenses and maintaining its capital expenditures. It simply tells you how much is left after the company pays costs to run its business. This money left can be spent by the company as it deems fit.
Some companies that issue out certain stock types such as income/dividend stocks use the money left to pay dividends to their shareholders. While some use it to invest in the growth of the company through acquisitions.
An FCF valuation and interpretation are essential when trying to choose good investments that will yield a return on capital. Growing free cash flows are usually a preliminary to increased earnings. Companies that experience a rapid increase in their free cash flow as a result of share buybacks, efficiency improvements, revenue growth, debt elimination, cost reductions, or dividend distributions, tend to reward investors in the future. This is why many people in the investment community cherish free cash flow as a measure of value.
It is assumed that when the share price of a company is low and the free cash flow is on the rise, it is a good sign that earnings and share market value will soon increase. More so, companies and businesses with FCF are likely to expand or obtain another business to add to their portfolio.
Conversely, a shrinking free cash flow may be an indication that companies are not able to sustain earnings growth. This is because an insufficient free cash flow for earnings growth can make companies boost debt levels.
It can alternatively cause companies to not have the liquidity to stay in business. However, a shrinking FCF may not necessarily be a bad thing especially, if the increasing expenses on capital assets (capital expenditures) are used to invest in the company’s growth. In such an instance there could be a future increase in the company’s revenues and profits.
Even as a business owner, calculating the free cash flow of your business can tell you whether to expand your business. If your business has FCF, it indicates that your business is in a good position to expand. Expansion for you could mean hiring more staff, adding an office, or even investing in or acquiring a competing business. The free cash flow can also tell whether earnings would increase. This is why investors look at the company’s free cash flow before investing.
The concept is that a consistent FCF predicts a possible surge in future earnings, thus, making the business attractive to investors. This metric can also indicate whether a business needs to restructure. Virtually every growing business at one time has faced a negative free cash flow. When there is a consistent low or negative free cash flow it might be a signal that the business needs to look at possible restructuring to be able to raise the free cash flow levels.
Nevertheless, not all companies use FCF as a measure of financial success or stability. Companies that don’t usually make long-term investments as part of their business model will be more in line with using net income as an indicator of financial performance. Such companies include service businesses, financial institutions, and banks. Manufacturing companies, on the other hand, that usually invest in factories or heavy equipment will be more in line with using free cash flow as an indicator of financial performance.
Free cash flow formula
The easiest way to calculate free cash flow is to find the capital expenditures on the cash flow statement and then subtract them from the operating cash flow in the cash flow statement. The free cash flow formula for this is expressed as:
Free cash flow= Operating cash flow – Capital expenditures
Nevertheless, there are other ways for FCF calculation which include using these FCF formulas:
Free cash flow= Sales revenue – (Operating costs + Taxes) – Required investments in operating capital,
or
Free cash flow= Net operating profit after taxes – Net investment in operating capital
Free cash flow formula from operating cash flow
Using operating cash to calculate free cash flow is the most common method used. The FCF formula for this is expressed as:
Free cash flow= Operating cash flow – Capital expenditures
This free cash flow formula from operating cash flow is the simplest and uses just two numbers that are easily found in financial statements- operating cash flow and capital expenditures. When using this method to calculate the FCF, locate the item cash flow from operations in the cash flow statement. The cash flow from operations is also known as the net cash from operating activities or operating cash) and then subtract the capital expenditure, which is found on the balance sheet.
Free cash flow formula using sales revenue
Another method is to use the sales revenue to calculate the FCF. The free cash flow formula for this is expressed as:
Free cash flow= Sales revenue – (Operating costs + Taxes) – Required investments in operating capital
Where,
Required investments in operating capital= Year 1 total net operating capital – Year 2 total net operating capital
Total net operating capital= Net operating working capital + Net plant, property, and equipment (Operating long-term assets)
Net operating working capital= Operating current assets – Operating current liabilities
Operating current assets= Cash + Accounts receivables + Inventory
Operating current liabilities= Accounts payables + Accruals
This particular free cash flow formula uses sales revenue. It focuses on the revenue that the company makes through its business and then subtracts the costs associated with making the revenue. The source of information for this method is the income statement and balance sheet.
In order to calculate the FCF, first, locate the item sales or revenue on the income statement, then subtract the sum of taxes and all operating costs (this can be listed as operating expenses). The operating cost will include items such as the cost of goods sold (COGS) and selling, general, and administrative costs (SG&A). After that, subtract the required investments in operating capital. The required investment in operating capital is derived from the balance sheet and is also referred to as the net investment in operating capital.
Free cash flow formula with net operating profits
Another method is to calculate the free cash flow using net operating profits after taxes (NOPAT). This method is similar to the FCF calculation using the sales revenue but in this method, the operating income is used. In this method, the free cash flow formula is expressed as:
Free cash flow= Net operating profit after taxes – Net investment in operating capital
Where,
Net operating profit after taxes= Operating income × (1 – Tax rate)
Operating income= Gross profits – Operating expenses
Net investment in operating capital= Year 1 total net operating capital – Year 2 total net operating capital
Total net operating capital= Net operating working capital + Net plant, property, and equipment (Operating long-term assets)
Net operating working capital= Operating current assets – Operating current liabilities
Operating current assets= Cash + Accounts receivables + Inventory
Operating current liabilities= Accounts payables + Accruals
Alternative FCF calculation
Apart from the three methods discussed above, there is another way for FCF calculation. This method uses the free cash flow formula from net income expressed as:
Free cash flow= Net income + Depreciation/Amortization – Change in working capital – Capital expenditure
In this calculation for free cash flow, the income statement, cash flow statement, and balance sheet are used. The first step is to start with the net income and then add back the charges for depreciation and amortization. Then calculate your working capital which is done by subtracting current liabilities from current assets. This makes the additional adjustment for changes in working capital. Lastly, subtract the capital expenditure in order to get the FCF.
It might seem off to add back depreciation/amortization because it accounts for capital spending. However, the concept behind this is that free cash flow is meant to measure the current money being spent and not past transactions. So, this makes free cash flow an essential metric for identifying companies that are growing with high up-front costs which may affect earnings in the present but have the potential to pay off in the future.
Free cash flow calculation
In financial statements, the free cash flow is not listed as a line item. Hence, it has to be calculated by using line items found in financial statements. The easiest way to calculate free cash flow is to find the capital expenditures on the cash flow statement and then subtract them from the operating cash flow in the cash flow statement.
However, this is not the only way as there are different methods used to calculate free cash flow. This is because all companies have different financial statements. The FCF can be calculated using operating cash flow, sales revenue, and net operating profits. Despite the method used, the final result should be the same given the information the company provides.
How to find free cash flow example 1
Mr. Johnson owns and runs a plastic manufacturing plant that manufactures packaging containers. For the fiscal year 2021, Mr. Johnson had an operating cash flow of $800,000 on his annual cash flow statement. In that same period of time, he spent $350,000 on three new machines for the plant operations. Calculate the free cash flow of Mr. Johnon’s business.
Solution
Here is the calculation for free cash flow using the FCF formula:
Free cash flow= Operating cash flow – Capital expenditures
Where,
Operating cash flow= $800,000
Capital expenditures= $350,000
FCF= $800,000 – $350,000= $450,000
This means that Mr. Johnson has $450,000 in free cash flow that can be used for his business.
How to calculate free cash flow example 2
Let’s assume a small-scale farm business spent $500 maintaining its capital assets and has an operating cash flow of $1,700. What will be the farm’s free cash flow?
Solution
Here is the calculation for free cash flow using the FCF formula:
Free cash flow= Operating cash flow – Capital expenditures
Where,
Operating cash flow= $1,700
Capital expenditures= $500
FCF= $1700 – $500= $1200
The farm’s free cash flow is $1200.
FCF calculation example 3
Assuming a firm has the following information:
- Net income- $3500
- Capital expenditure- $700
- Non-cash expense- $400
- Increase in working capital- $350
Given the above information, calculate the cash flow of the company.
Solution
Here is the calculation for FCF using the free cash flow formula:
Free cash flow= Net income + Depreciation/Amortization – Change in working capital – Capital expenditure
Where,
Net income= $3500
Depreciation/Amortization= Non-cash expenses= $400
Change in working capital= $350
Capital expenditure= $700
FCT= $3500 + $400 – $350 – $700 = $2850
This means the free cash flow of the company is $2,850.
Other types of free cash flow formula
- Free cash flow to firm (FCFF)
- Free cash flow to equity (FCFE)
Listed above are the two types of free cash flow.
Free cash flow to the firm (FCFF)
The FCFF is the amount of cash flow from operations that the company has for distribution after taking care of taxes, depreciation expenses, investments, and working capital. The free cash flow to the firm can be calculated by using the cash flow operations or the net income of the company. This type of free cash flow is also called unlevered free cash flow. The formula for this is expressed in various forms. One of the common equations used for the FCFF is:
FCFF= Net income + Non-cash charges + {Interest × (1- Tax rate)} – Long term investments – Investments in working capital
There is also a free cash flow formula from EBITDA expressed as:
FCFF= {EBITDA × (1-Tax rate)} + (Depreciation × Tax rate) – Long term investments – Investments in working capital
Where,
EBITDA= Earnings before interest, taxes, depreciation, and amortization
Free cash flow to Equity (FCFE)
FCFE is the measure of the amount of cash available to the equity shareholders of the company after all reinvestment, debt, and expenses are paid. This type of FCF is also called levered free cash flow and is the amount of cash that can be distributed to the company’s equity shareholders as dividends or stock buybacks after all reinvestment, debt, and expenses are paid. The FCFE formula for this is expressed as:
FCFE= Cash from operations – Capital expenditures + Net debt issued
If there is no preferred stock outstanding, the free cash flow for equity formula is expressed as:
FCFE= FCFF+ net borrowing – Interest × (1 – Tax)
The free cash flow for equity formula can also be expressed as:
FCFE= Net income + Depreciation & Amortization – Capital expenditure – Change in working capital + Net borrowings
Free cash flow vs Net cash flow
There is a significant difference between free cash flow vs net cash flow. Free cash flow tends to be more specific than net cash flow. It looks at the amount of cash generated by a company through its operating activities after accounting for capital expenditures and operating expenses. Net cash flow, on the other hand, looks at the amount of cash a company generates which includes financing, operating, and investing activities. The net cash flow of a company can be positive or negative depending on whether the company has more cash inflows compared to its cash outflows.
Benefits
Free cash flow when calculated will measure the cash amount that a company will pay as interest and principal repayment to bondholders. It also takes into account the cash that the company could pay in dividends to shareholders if need be. Free cash flow is essential because it gives a reasonable insight into the financial health of a company.
This metric is made up of a variety of components in the financial statement, thus, when its composition is clearly understood, it can give investors a lot of useful information. Additionally, cash flow from operations takes into account the increases and decreases in assets and liabilities
Some investors are more comfortable using free cash flow rather than net income to measure the financial performance of a company as well as calculate the company’s intrinsic value. This is because free cash flow is more difficult to manipulate compared to net income. The higher the FCF, the better.
Limitations of the free cash flow formula
One major disadvantage of using the free cash flow formula and method is that the capital expenditures between different industries can vary dramatically from year to year. Hence, it is important to measure the free cash flow over multiple periods and against the backdrop of a firm’s industry.
A rising cash flow is usually interpreted as an indicator that the company is likely to grow in the future. Due to this, value investors usually look for companies with high or improving cash flows that have undervalued share prices. However, it is crucial to keep in mind that an extremely high free cash flow may be an indication that the company is not investing in its business properly. The business may not be doing things like maintaining and updating its plant and equipment.
More so, profitable businesses may have negative free cash flow. In essence, a negative free cash flow may not necessarily mean that the company is in a financial crisis. It may mean that the company is investing heavily in expanding its market share which would probably lead to future growth.
FAQs
What is a good free cash flow per share?
A high free cash flow per share can be considered ideal. This is because when the price of a share is low and the free cash flow is improving, the odds are good, indicating that earnings and share value will soon be on the rise. Hence, a high cash flow per share value means that earnings per share would potentially be high too.
What is free cash flow in stocks?
When dealing with stocks, the free cash flow per share of a company is calculated. This metric tells the financial flexibility of a company which is derived by dividing free cash flow by the total number of shares outstanding.
What is the free cash flow of a company?
The free cash flow of a company is the cash generated by the company after it has taken care of the expenses that maintain the company’s capital asset and cover the company’s operations. In order words, it is the cash left over after a company foots its operating expenses and capital expenditures (CapEx).
What is free cash flow per share formula?
The free cash flow per share formula is expressed as Free cash flow / Shares outstanding. This metric tells the financial flexibility of a company which is derived by dividing free cash flow by the total number of shares outstanding.
What is the levered free cash flow formula?
The levered free cash flow formula is expressed as LFCF= EBITDA – Change in net working capital – Capital expenditures – Mandatory debt payments. This levered free cash flow is the cash available after a company has settled all its financial obligations.
What is the free cash flow conversion formula?
The free cash flow conversion formula is expressed as FCF Conversion = Free Cash Flow / EBITDA. The FCF Conversion rate is a liquidity ratio. This ratio measures the ability of a company to convert its operating profits into FCF in a given period of time.
What is the free cash flow margin formula?
Free cash flow margin compares the free cash flow of a company to its sales or revenue. The free cash flow margin formula is expressed as FCF Margin = FCF / revenues.
Obotu has 2+years of professional experience in the business and finance sector. Her expertise lies in marketing, economics, finance, biology, and literature. She enjoys writing in these fields to educate and share her wealth of knowledge and experience.
