Free Cash Flow: How to Calculate and Interpret This Key Metric
Updated March 22, 2023.
Free cash flow (FCF) is a critical metric that an organization's management and investors can refer to when determining a company's financial stability. It reconciles net income by adjusting for things like capital expenditures, non-cash expenses, and changes in working capital.
This article looks at the intricacies of free cash flow, how to calculate it, and how to interpret it. This information can be used with other metrics to understand a company's overall financial health better.
What Is Free Cash Flow?
Free cash flow represents the cash a company generates after cash flows for operational support and capital asset maintenance have been accounted for.
As opposed to net income, FCF measures profitability without including the non-cash expenses of an income statement or interest payments. But it does include spending on assets and equipment and any changes in working capital from the balance sheet.
FCF has many variations that analysts and investment bankers can use to evaluate a company's projected performance with varying capital structures. These variations include FCF to equity and FCF for the firm, which are adjusted for borrowings and interest payments.
» Get a refresher on the basics with this guide to profit and loss statements
Why Is Free Cash Flow Important?
FCF is an excellent way to accurately assess a business's worth and determine its fundamental trends. Taking working capital into account makes FCF a profitability metric that provides an additional layer of insight that may not be readily gleaned from the income statement. FCF can also help lenders and potential shareholders assess a company's capacity to pay expected dividends or interest.
For example, a lender can have a better idea of the cash flows a company has for additional borrowings by deducting the company's debt payments from FCF to the firm.
How Do You Calculate Free Cash Flow?
There are two ways to calculate FCF.
Approach 1
First, you can start at the cash flow statement and select cash flows from operating activities, as this number has already considered non-cash expenses and alterations in working capital. Then, make adjustments from interest expense, tax shield on interest expense, and capital expenditures for that year:
| Factor | Location |
|---|---|
| + Cash flow from operating activities | Cash flow statement |
| + Interest expense | Income statement |
| - Capital expenditures (CAPEX) | Cash flow statement |
| = Free cash flow | |
Approach 2
Secondly, you can use earnings before interest and taxes (EBIT) as a starting point. Then, adjust for income taxes, non-cash expenses like amortization and depreciation, any changes in working capital, and capital expenditures.
| Factor | Location |
|---|---|
| + EBIT x (1 - Tax rate) | Income statement |
| + Non-cash expenses | Income statement |
| - Changes in (current assets - current liabilities) | Balance sheet |
| - Capital expenditures (CAPEX) | Cash flow statement |
| = Free cash flow | |
The formula can also be further simplified as:
FCF = Net Cash from Operating Activities - Capital Expenditures
You can choose whichever approach works best depending on the financial information that you have. Regardless of the approach, the results should be identical.
Interpreting Free Cash Flow
FCF is a critical metric representing a company's solvency, the potential for growth, and overall financial sustainability.
What Does Free Cash Flow Indicate?
Healthy FCF numbers are typically a good sign that a business is stable. However, the complete context must always be taken into account. For example, a company that has a high FCF because it postponed crucial capital expenditure investments might not be such a good thing.
Conversely, a company with a low FCF but enough to invest in its growth and sustain operations may not be doomed to fail just because it has a low number.
How to Define Good Free Cash Flow
Analyzing the stability of a company's FCF trends is an efficient way to evaluate risk. If its FCF trends appear consistent over 4-5 years, then there are fewer odds that bullish stock patterns will be derailed. But if FCF trends decline, especially if they deviate sharply from their corresponding earnings and sales trajectories, it likely means that shareholders will experience more negative price performances.
Example of Free Cash Flow
Let's take a look at a sample company's FCF and interpret what it means:
| Factor | 2019 | 2020 | 2021 |
|---|---|---|---|
| Sales / revenue | $120 | $126 | $128 |
| Earnings per share | $1.15 | $1.17 | $1.19 |
| Free cash flow | $1.07 | $1.05 | $0.80 |
In this example, the company's revenue figures heavily contrast its cash flow. This should raise a red flag for an investor—it may hint at underlying issues that have yet to appear in headline numbers, such as revenue and earnings per share.
The problems may be due to several factors, such as the company investing in property, plant, and equipment for business growth. Low cash flows may also indicate that too many resources are stockpiled in inventory.
Limitations of Free Cash Flow
FCF is a metric that looks at the amount of money left after expenses, and it can be a more erratic metric than net income. For instance, cash flow could be negative if an organization purchases a new property while net income stays positive. This disparity emphasizes the importance of considering both metrics when assessing your business's financial performance.
» Consider the pros and cons of cash flow forecasting
Easily Free Up Your Cash Flow
Due to the temporary fluctuation inherent in FCF, many investors lean towards evaluating a company's financial stability through net income since it smooths out profitability highs and lows. However, when viewed over an extended timeframe, FCF offers a more insightful picture of a company's operational results.
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