What Is Free Cash Flow (FCF)?
Free cash flow (FCF)is the cash a companygenerates after taking into consideration cash outflows that support its operations and maintain its capital assets. In other words, free cash flow is the cash left over after a companypays forits operating expenses (OpEx)and capital expenditures (CapEx).
FCF is the money that remains after paying for items such as payroll, rent, and taxes, and a company can use it as it pleases. Knowing how to calculate free cash flow and analyze it will help a company with its cash management. FCF calculation will also provide investors with insight into a company’s financials, helping them make better investment decisions.
Free cash flowis an important measurement since itshows how efficient a company isat generating cash. Investors use free cash flow to measure whether a company might have enough cash for dividends or share buybacks. In addition, the more free cash flow a company has, the better it is placed to pay down debt and pursue opportunities that can enhance its business, making it an attractive choice for investors.
This article will cover how a company calculates free cash flow and how to interpret that FCF number to choose good investments that will generate a return on your capital.
Key Takeaways
- Free cash flow (FCF) is the money a company has left over after paying its operating expenses (OpEx) and capital expenditures (CapEx).
- The more free cash flow a company has, the more it can allocate to dividends, paying down debt, and growth opportunities.
- There are three ways to calculate free cash flow: using operating cash flow, using sales revenue, and using net operating profits.
- If a company has a decreasing free cash flow, that is not necessarily bad if the company is investing in its growth.
- Free cash flow is just one metric used to gauge a company’s financial health; others include return on investment (ROI), debt-to-equity (D/E) ratio, and earnings per share (EPS).
How to Calculate Free Cash Flow (FCF)
There are three different methods to calculate free cash flow because all companies don’t have the same financial statements. Regardless of the method used, the final number should be the same given the information that a company provides. The three ways to calculate free cash flow are by using operating cash flow, using sales revenue, and using net operating profits.
Using Operating Cash Flow
Using operating cash flow to calculate free cash flow is the most common method because it is the simplest and uses two numbers that are readily found in financial statements: operating cash flow and capital expenditures. To calculate FCF, locate the itemcash flow from operations(also referred to as “operating cash” or “net cash from operating activities”) from the cash flow statement and subtract capital expenditure, which is found on the balance sheet.
The formula is:
FreeCashFlow=OperatingCashFlow−CapitalExpenditures
Using Sales Revenue
Using sales revenue focuses on the revenue that a company generates through its business and then subtracting the costs associated with generating that revenue. This method utilizes the income statement and balance sheet as the source of information. To calculate FCF, locate sales or revenue on the income statement, subtract the sum of taxes and all operating costs (or listed as “operating expenses”), which include items such as cost of goods sold (COGS) and .
Finally, subtract the required investments in operating capital, also known as the net investment in operating capital, which is derived from the balance sheet.
The formula is:
FreeCashFlow=SalesRevenue−(OperatingCosts+Taxes)−RequiredInvestmentsinOperatingCapitalwhere:RequiredInvestmentsinOperatingCapital=YearOneTotalNetOperatingCapital−YearTwoTotalNetOperatingCapitalandwhere:TotalNetOperatingCapital=NetOperatingWorkingCapital+NetPlant,Property,andEquipment(OperatingLong-TermAssets)andwhere:NetOperatingWorkingCapital=OperatingCurrentAssets−OperatingCurrentLiabilitiesandwhere:OperatingCurrentAssets=Cash+AccountsReceivables+InventoryOperatingCurrentLiabilities=AccountsPayables+Accruals
Using Net Operating Profits
To calculate free cash flow using net operating profits after taxes (NOPATs) is similar to the calculation of using sales revenue, but where operating income is used.
The formula is:
FreeCashFlow=NetOperatingProfitAfterTaxes−NetInvestmentinOperatingCapitalwhere:NetOperatingProfitAfterTaxes=OperatingIncome×(1-TaxRate)andwhere:OperatingIncome=GrossProfits−OperatingExpenses
The calculation for net investment in operating capital is the same as described above.
Example of Free Cash Flow Calculation
Macy’s Inc. (M)
Macy'scash flow statementfor the fiscal yearending2019, according tothe company’s10-K statement, indicates:
Cash Flow from Operating Activities = $1.608 billion
Capital Expenditures = $1.157 billion
Interpreting Free Cash Flow
We can see that Macy’shasa large amount of free cashflow, which can be used to pay dividends, expand operations, and deleverage its balance sheet (i.e.,reduce debt).
From 2017 until now, Macy’s capital expenditures have been increasing due to its growth in stores, while its operating cash flow has been decreasing, resulting in decreasing free cash flows.
Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF—due to revenue growth, efficiency improvements, cost reductions, share buybacks, dividend distributions, or debt elimination—can reward investors tomorrow. That is why many in the investment community cherish FCF as a measure of value. When a firm’s share price is low and free cash flow is on the rise, the odds are good that earnings and share value will be heading up soon.
By contrast, shrinking FCF might signal thatcompanies are unable to sustain earnings growth. An insufficient FCF for earnings growth can force companies to boost debt levels ornot have theliquidityto stay in business. That being said, a shrinking FCF is not necessarily a bad thing, particularly if increasing capital expenditures are being used to invest in the growth of the company, which could increase revenues and profits in the future.
Amortization and Depreciation
To calculate free cash flowanother way,locatethe income statement, balance sheet, and cash flow statement. Start with net income and add back charges for depreciation and amortization. Make an additional adjustment for changes inworking capital, which is done by subtracting current liabilities from current assets. Then subtract capital expenditure (or spending on plants and equipment):
| Net Income |
| + Depreciation/Amortization |
| - Change in Working Capital |
| - Capital Expenditure |
| = Free Cash Flow |
It might seem odd to add back depreciation/amortization since it accounts for capital spending. The reasoning behind the adjustment is that free cash flow is meant to measure money being spent right now, not transactions that happened in the past. This makes FCF a useful instrument for identifying growing companies with high up-front costs, which may eat into earnings now but have the potential to pay off later.
Benefits of Free Cash Flow
Free cash flow can provide a significant amount of insight into the financial health of a company. Because free cash flow is made up of a variety of components in the financial statement, understanding its composition can provide investors with a lot of useful information.
Of course, the higher the free cash flow, the better. But we have already seen from our Macy’s example that a declining free cash flow is not always bad if the reason is from further investments in the company that poise it to reap larger rewards down the line.
In addition, cash flow from operations takes into consideration increases and decreases in assets and liabilities, allowing for a deeper understanding of free cash flow. So for example, if accounts payable continued to decrease, it would signify that a company is paying its suppliers faster. If accounts receivable were decreasing, it would mean that a company is receiving payments from its customers faster.
Now, if accounts payable was decreasing because suppliers wanted to be paid quicker but accounts receivable was increasing because customers weren’t paying quickly enough, this could result in decreased free cash flow, since money is not coming in quickly enough to meet the money going out, which could result in problems for the company down the line.
The overall benefits of a high free cash flow, however, mean that a company can pay its debts, contribute to growth, share its success with its shareholders through dividends, and have prospects for a successful future.
Limitations of Free Cash Flow
One drawback to using the free cash flowmethod is thatcapital expenditures can vary dramatically from year to year and among different industries.That’s why it’s critical to measure FCF over multiple periods and against the backdrop of a company’sindustry.
It’s important to note that an exceedingly high FCF might bean indication that a company is not investing in itsbusiness properly, such as updating its plant and equipment. Conversely, negative FCF might not necessarily mean a company is in financial trouble, but rather, investing heavily in expandingits marketshare, which would likely leadto future growth.
Value investors often look for companies with high or improving cash flows but with undervalued share prices. Rising cash flow is often seen as an indicator thatfuture growth is likely.
How do you calculate free cash flow (FCF)?
There are three ways to calculate free cash flow: using operating cash flow, using sales revenue, and using net operating profits. Using operating cash flow is the most common and the most simple. It is calculated by subtracting capital expenditures from operating cash flow.
What does free cash flow tell you?
Free cash flow tells you how much cash a company has left over after paying its operating expenses and maintaining its capital expenditures—in short, how much money it has left after paying the costs to run its business. Free cash flow can be spent by a company however it sees fit, such as paying dividends to its shareholders or investing in the growth of the company through acquisitions, for example.
Where is free cash flow in the financial statements?
Free cash flow is not a line item listed in financial statements. Instead, it has to be calculated using line items found in financial statements. The simplest way to calculate free cash flow is by finding capital expenditures on the cash flow statement and subtracting it from the operating cash flow found in the cash flow statement.
What is the difference between free cash flow and net cash flow?
Net cash flow takes a look at how much cash a company generates, which includes cash from operating activities, investing activities, and financing activities. Depending on if the company has more cash inflows vs. cash outflows, net cash flow can be positive or negative. Free cash flow is more specific and looks at how much cash a company generates through its operating activities after taking into account operating expenses and capital expenditures.
The Bottom Line
Free cash flow is a metric that investors use to help analyze the financial health of a company. It looks at how much cash is left over after operating expenses and capital expenditures are accounted for. In general, the higher the free cash flow is, the healthier a company is, and in a better position to pay dividends, pay down debt, and contribute to growth.
Free cash flow is one of many financial metrics that investors use to analyze the health of a company. Other metrics investors can use include return on investment (ROI), the quick ratio, the debt-to-equity (D/E) ratio, and earnings per share (EPS).
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Macy’s, via U.S. Securities and Exchange Commission. “Form 10-K for the Fiscal Year Ended February 1, 2020,” Pages 19 and F-10 (Pages 19 and 58 of PDF).
