Free Cash Flow (FCF)

What is Free Cash Flow?

Free cash flow (FCF) is the cash a company generates from operations after paying for capital expenditures (CapEx) needed to maintain or expand its asset base. It represents the cash available to repay creditors, pay dividends, buy back shares, or reinvest in the business.

Why FCF matters

• Shows the company’s true cash-generating ability, beyond accounting profit.
• Helps assess capacity to pay dividends, service debt, and fund growth.
• Reveals operational or working-capital issues that may not appear on the income statement.
• Often used by investors and analysts to evaluate financial health and valuation.

How to calculate FCF

The simplest and most common formula:
FCF = Cash flow from operating activities − Capital expenditures (CapEx)

Alternative component-based formulas:
– From net income:
FCF = Net income + Depreciation & amortization − Change in working capital − CapEx
– From EBIT (used for firm-level measures such as FCFF):
FCFF = EBIT × (1 − tax rate) + Depreciation & amortization − Change in working capital − CapEx

Important note: Interest payments are typically excluded from the general FCF definition; adjustments for interest and debt flows produce variations like FCFF and FCFE (free cash flow to equity).

Variations to know

• Free Cash Flow to the Firm (FCFF): cash available to all capital providers (debt and equity) after taxes and reinvestment.
• Free Cash Flow to Equity (FCFE): cash available to equity holders after debt payments and net borrowings are accounted for.
• Analysts choose a variation depending on whether they’re evaluating firm value or equity value.

Benefits of using FCF

• Incorporates working capital changes, highlighting operational issues (e.g., rising receivables or inventory).
• Indicates the sustainability of dividends and capacity for share buybacks.
• Helps detect divergences between reported earnings and actual cash performance.

Limitations and caveats

• Volatility from CapEx: large, lump-sum investments can make FCF swing wildly year to year.
• Depreciation timing and methods affect the relationship between net income and FCF.
• Not a standardized GAAP line item — must be calculated from financial statements, which allows for inconsistent treatment and possible manipulation via timing.
• Positive FCF doesn’t guarantee good stock performance; context and trends matter.

Interpreting FCF

• Focus on trends over multiple years rather than single-year values.
• Evaluate FCF per share to account for dilution from new shares.
• Compare FCF to dividends paid, interest obligations, net debt levels, and investment needs.
• Use alongside other metrics (revenue growth, margins, return on invested capital) for a fuller picture.

Practical red flags
– Declining FCF while revenue and net income remain steady — may indicate worsening working capital or rising CapEx.
– Consistently negative FCF without clear growth investments — potential sustainability issues.
– Large, repeated CapEx without corresponding revenue or margin improvement.

Example

If a company reports:
– Cash flow from operating activities = $80 million
– Capital expenditures = $25 million
Then:
FCF = $80M − $25M = $55M

This $55 million is available for dividends, debt repayment, share buybacks, or reinvestment (subject to management priorities and obligations).

Conclusion

Free cash flow is a key measure of a company’s financial flexibility and real cash profitability. It’s most informative when examined over time and in context with CapEx plans, working capital trends, and the company’s financing needs. Use FCF alongside other financial indicators to form a balanced view of a company’s health and prospects.