How to Calculate Your Free Cash Flow (2024)

Any company that wants to fund growth must generate more cash than just what it needs to meetday-to-day operating expenses. Public companies might pay shareholder dividends, whileprivate businesses may use free cash to add product lines or make an acquisition.

How can you measure whether your company is generating the cash it needs to invest in itsfuture? Enter free cash flow, a key financial metric.

What Is Free Cash Flow (FCF)?

Free cash flow (FCF) is the money a company has left from revenue after paying all itsfinancial obligations—defined as operating expenses pluscapital expenditures—during a specific period, such as a fiscal quarter. FCF is thecash acompany is free to use for discretionary spending, such as investing in business expansionor building financial reserves.

Operating Cash Flow vs Free Cash Flow

Operating cash flow and free cash flow are both important measures of a business’financialhealth, but have key differences.

Operating cash flow is the netcash inflows and outflows during an accounting period—in other words, all the revenuecomingin minus all the expenses paid out. It can be found on a company’s cash flowstatement,where it’s sometimes listed as “cash flow from operating activities” or“net cash generatedfrom operations.” Operating cash flow is a standard metric under U.S. GenerallyAcceptedAccounting Principles, a set of rules issued by the Financial Accounting Standards Board(FASB).

However, operating cash flow has limitations as a metric because it doesn’t includethe costof acquiring and maintaining fixed assets or the effect of changes in working capital, whichoften signal that a business is struggling. Free cash flow takes these factors into account,and therefore can provide a better picture of a company’s ability to generate the cash*tneeds to grow and pay creditors and investors.

Video: What Is Free Cash Flow?

Key Takeaways:

• Because cash is top priority in a business—both to meet operating expenses andinvest inthe future—free cash flow can reveal important insights into the health of anycompany.
• The basic free cash flow formula is simple: operating cash flow minus capital expense.It’s what you have left after paying operating and capital costs.
• Levered free cash flow reveals how much cash a business generates after accounting fordebt.
• Unlevered free cash flow is a hypothetical measure showing how much free cash thebusiness would generate if it had no debt. It can be used to estimate a company’senterprise value.
• Sustained positive free cash flow can help a company get better terms when borrowing forexpansion. But by itself, free cash flow can be misleading. It’s volatile bynature soit should be analyzed over several periods and viewed in conjunction with other metrics.

Why is Free Cash Flow Important?

In business, profits are important but cash is singularly vital. Companies need cash to paytheir operating expenses and other immediate financial obligations. But they also need cashto develop new products, expand operations and make acquisitions—the activities bywhichcompanies live and die over the long term. That’s why FCF is such a crucial measure ofabusiness’ health.

FCF metrics are invaluable for business managers, creditors and investors:

• Business managers use FCF to monitor performance and inform plans forfuture expansion.
• Creditors use FCF to help determine how much debt a company cansupport.
• Investors use a variation—levered free cash flow, also calledfree cashflow to equity (FCFE )—to indicate how much cash could potentially beredistributed toshareholders in the form of dividends.

Companies that don’t have much cash left over after all the bills are paid often finditdifficult to borrow or attract investors.

Types of Free Cash Flow

There are three main types of free cash flow metrics. They differ primarily based on how eachmetric treats debt. Still, all three views of free cash flow represented by the FCF metricscan offer insights into the business that are valuable to different stakeholders.

The basic FCF formula—operating cash flow minus capitalexpense—tells youthe amount of money left over after the business has met all its obligations, from both theoperating and capital perspectives, in that period. While FCF includes interest expense forthe period, it does not include new debt that the company may take on or account for debtthat it pays off.

Therefore, for example, it’s possible for FCF to look misleadingly positive if viewedbyitself for a period in which the company took on more debt, which would appear as a boost tocash flow.

Levered free cash flow, also known as free cash flow to equity(FCFE), differs from FCF because it includes changes in net debt—any newdebtthat the company incurs or loan balances that it pays off. The resulting number representsthe cash flow available to investors, who often mean “FCFE” even though they mayrefersimply to “free cash flow” or even just “cash flow.”

FCFE is most frequently used in financial analysis to determine a firm’s equity value.

Unlevered free cash flow, also known as free cash flow to the firm(FCFF), is a hypothetical figure used to estimate what a firm’s cash flowwouldlook like if it had no debt. Therefore, FCFF strips out the effect on cash flow of acompany’s debt liabilities, giving a better idea of the underlying business’real ability togenerate cash. Firms that carry significant debt often report unlevered free cash flow. FCFFprojections are used in financial modeling as a way to calculate enterprise value.

How to Calculate Free Cash Flow

Baseline FCF is calculated by subtracting capital expenditure from the company’s cashflowfrom operations. Both figures appear in the company’s cash flow statement. If thecompanydoesn’t produce a cash flow statement, FCF can also be calculated from current andpreviousincome statements and balance sheets.

FCFE can be calculated by deducting net debt issuance from FCF or adding net debtrepayment back to it. In other words, if a company issues a $100 million bond during theperiod in question and pays off a $50 million loan, it had net debt issuance of $50 million.That amount must be deducted from FCF to arrive at FCFE. In periods during which there isnet debt repayment, the amount would be added to FCF to obtain FCFE.

When it comes to the hypothetical FCFF, there are multiple ways to calculate it, allinvolving data from a company’s income and cash flow statements along with informationabouttax rates. But they all share a common goal: Strip away the effects of a business’capitalstructure to reveal its inherent FCF potential.

What Is the Free Cash Flow Formula?

Naturally, the three free cash flow calculations have different formulas. Let’s walkthrougheach, then illustrate them with examples.

The basic formula for FCF is:

FCF = Operating cash flow – capitalexpenditure

This can be extended to get the formula for FCFE, thus:

FCFE = FCF – net debt issuance

Or, for added clarity:

FCFE = Operating cash flow – capital expenditure– (debtissued – debt repaid)

The formula for calculating FCFF, however, is not a simple extension of these. In fact,it’san entirely different ballgame. At the highest level, it can be expressed as:

FCFF = Unlevered operating cash flow –capitalexpenditure

The trick, though, is getting at unlevered operating cash flow. That requires multiplesteps, each with its own formula. To aid understanding, we’ve explained those in theexamples section, next.

Examples of Free Cash Flow

To illustrate calculations of the three free cash flow formulas, we’ve presentedsimplifiedexcerpts of real-life cash flow and income statements from a typical small manufacturingcompany. Let’s call it Michigan Widgets.

Note that operating cash flow—labeled “Net cash provided by operatingactivities” inMichigan Widget’s cash flow statement—starts with net income, then addsdepreciation andamortization expenses as well as changes in accounts receivable, inventory and accountspayable. Capital expense is found on the “Additions to property, plant andequipment” line.

If we use those numbers in the baseline FCF formula (FCF = OperatingCash Flow – Capital Expenditure) we get:

FCF = $2,552,000 – $1,374,000, or$1,178,000

To derive FCFE, we simply subtract net debt issuance, found in Michigan Widget’s cashflowstatement under “Cash flows from financing activities.”

FCFE = $1,178,000 - $2,367,000, or ($1,189,000)

As you can see, this is a case where FCFE reveals that the period’s FCF has beeninflated bynet debt issuance.

Calculating FCFF is more complex. Because the goal is to strip out the effect ofdebt—inother words, to unlever the business’ cash flow—FCFF calculations looklike this:

• Start by determining unlevered net income.
• Use that figure to calculate unlevered operating cash flow.
• And, finally, substitute the hypothetical unlevered operating cash flow number foroperating cash flow in the baseline FCF formula.

The steps for a typical FCFF formula are as follows.

1. Calculate the company’s unlevered net income: Start bycalculatingearnings before interest and taxes (EBIT) from Michigan Widgets’ incomestatement.To do this, take net income ($424,000) and add back interest expense ($550,000) andtaxes paid ($0); EBIT equals $974,000. Using information on tax rates, calculate thetax that the company would have paid if there were no interest expense. Sinceinterest on debt is tax deductible for a business (known as the “tax shield ondebt”), this will be higher than the actual tax paid. For the purposes of thisexercise, assume taxes are 10% of EBIT. Deduct this hypothetical tax amount fromEBIT to give the unlevered net income figure:

   Unlevered Net Income = $974,000 – $97,400, or$876,600

2. Calculate the company’s unlevered operating cash flow: Takethe tophalf of Michigan Widgets’ cash flow statement, substitute unlevered net income($876,000) for net income, and recalculate operating cash flow. Do this by addingback depreciation and amortization and any increase in non-cash working capital,such as accounts payable, accounts receivable and inventory. Of course, if there wasa decrease in noncash working capital, you’d deduct it.

   Excerpted Top of Michigan Widgets Cash FlowStatement
   Cash flows from operating activities
   Unlevered net income	877
   Adjustments to reconcile net income to net cash provided byoperating activities:
   Depreciation and amortization	1,927
   Change in accounts receivable	163
   Changes in inventory	63
   Changes in accounts payable	(25)
   Unlevered net cash provided by operatingactivities	3,005

3. Finally, use the FCF formula to calculate FCFF: Remember, thebaseline FCF formula is operating cash flow—which now, unlevered, is$3,005,000—minus capital expense, or $1,374,000, from the original cash flowstatement. So:

   FCFF = $3,005,000 – $1,374,000, or$1,631,000

Benefits of Free Cash Flow

A good FCF can enable companies to borrow for expansion, since it reassures lenders that thecompany is capable of generating the cash it needs to service additional debt. And, asalready discussed, FCF is a key measure of business performance and potential that tellsleadership how much they have available to invest in new projects, acquire a business orredistribute to shareholders.

Further, FCF informs investors about the likely future performance of a company. A firm thatis generating significant positive FCF year-on-year is often a good investment prospect.However, companies that have negative FCF can also be smart investments, if the reason forthe negative FCF is that the company is investing heavily in, say, plant and machinerythat’s expected to deliver a good return in the future.

Limitations of Free Cash Flow

The principal limitation of FCF is that it applies the entire cost of capital expenditure inthe period in which the property or equipment was acquired, rather than spreading it overseveral periods as the main financial statements do. As a result, FCF can give a misleadingimpression of a company’s cash position, understating it in the period when a capitalacquisition is made and overstating it in subsequent periods.

Additionally, when there are repeated capital expenditures over a number of reportingperiods, year-on-year FCF can be much more volatile than net income or operating cash flow.

When a capital expenditure is debt-financed, FCFE can be particularly misleading because itapplies the cost of the capital acquisition plus the debt issued to finance it in the sameperiod. The example above shows how a significant debt-financed capital expenditure can makeFCFE turn sharply negative. In some industries, such as oil and mining, large capital assetbases financed with debt are normal. For companies in these industries, sudden sharplynegative FCFE is not necessarily a matter for concern.

FCFF can be a helpful metric for companies in industries where high leverage is normal.However, by itself, it can give a misleading impression of solvency. Positive FCFF does notindicate that a highly leveraged company would survive a business interruption or economicdownturn. In fact, because it excludes debt service costs, positive FCFF may not even meanthe company can afford its present level of debt.

The Bottom Line on Free Cash Flow

Free cash flow metrics are invaluable for business managers, investors and creditors.Business managers use FCF to monitor business performance and inform plans for futureexpansion. Investors use FCFE to measure the cash generation capability of the company andindicate how much cash could potentially be redistributed to shareholders. Financialanalysts use FCFE and FCFF in discounted cash flow models that calculate, respectively, theequity and enterprise values of a company. Creditors use FCF to help them determine thelevel of borrowing that a company can support.

However, FCF metrics by themselves do not give a complete picture of a business’financialhealth. They should always be considered in light of what is normal for the industry and inconjunction with the main financial statements and other metrics. And because FCF is bynature volatile, it should also be viewed over multiple reporting periods.