Ultimate Guide to Free Cash Flow – Everything You Need To Know

Free Cash Flow (aka FCF). Perhaps one of the most important financial figures of them all. And yet, it’s often overlooked by many an investor who prefers to focus on Net Profit instead. In this article, we’ll explore what Free Cash Flow is and why it’s so crucial.

Let’s get into it.

What Is Free Cash Flow?

Firstly, what is Free Cash Flow (FCF)?

In a nutshell…

Free Cash Flow is the cash flow that’s freely available to distribute to both debt as well as equity investors.

Note, importantly, that companies don’t have to distribute that cash flow to investors.

It’s freely available to distribute, but isn’t required to distribute.

Firms can choose to either distribute part of the FCF (e.g., use it to pay dividends to equity investors), or use it to fund projects that drive future growth.

Fundamentally, FCF is the cash flow a company has available after it pays for all of its operating and investing requirements in a given time period.

What it chooses to do with it is a separate question, and one that the Board of Directors and shareholders would determine.

Freely Available to Distribute

The idea that FCF is the cash flow that’s freely available to distribute to debt and equity investors is visible in the simplest formula for Free Cash Flow:

   

Here refers to Free Cash Flow. denotes Operating Cash Flow (which is largely synonyms with cash flow from operations). And represents ‘Capital Expenditure’‘.

It’s also visible, perhaps even more clearly, in the expanded formula for Free Cash Flow:

   

Where:

• denotes Free Cash Flow as before
• refers to Earnings Before Interest and Tax
• represents the corporate tax rate
• denotes Non Cash Expenses (e.g., depreciation, amortisation, etc)
• reflects the change in working capital, and
• represents the Capital Expenditure

Note that the two equations above are in fact identical.

That’s because the second version just provides an expanded view of Operating Cash Flow. In other words:

.

We’ll explore each and every one of these variables individually later on when we explore how to calculate free cash flow, so don’t fret if these equations are freaking you out right now.

At this stage, the only thing you need to take away is the fact that Free Cash Flow is cash flow that’s freely available to distribute to both debt and equity investors.

Now that that’s hopefully clear, let’s get clear on some common misconceptions.

Is Free Cash Flow the Same As Profit?

This is one area where many investors misunderstand financial statements and key financial metrics.

Free cash flow is not the same as profit (also known as net income). And this is partly because of:

• a difference of timing, and
• expense recognition requirements (which prevent certain cash outflows from showing up in the Income Statement (aka P&L))

We have a whole other article on the difference between cash flow and net income, and we’d encourage you to give that a read if you’re not clear on the differences.

That article focuses on cash flows in general, but the points there naturally relate to FCF, too.

Now, although FCF and Profit aren’t the same, FCF certainly does depend on Profit.

And “Profit” can theoretically include any form of profit (i.e., Gross Profit, Operating Profit, Net Profit)…

But the most common form of profit used to calculate FCF is the operating profit (aka EBIT).

This is likely followed by Net Profit, as the second most common form of profit that’s used to calculate FCF.

So in a nutshell, Free Cash Flow is not the same as profit. But we need profit in order to calculate FCF.

The reverse is not true. We don’t need FCF in order to calculate Net Income.

We’ll explore the different ways of calculating FCF further down. For now, let’s think about why FCF is important.

Why Is Free Cash Flow Important?

Free Cash Flow is an important metric because it gives investors and analysts a true sense of financial health of a company.

Thanks to dime a dozen accounting conventions, the profitability of a firm doesn’t necessarily say anything about its financial stability.

A firm could be highly profitable whilst simultaneously be at the brink of insolvency or bankruptcy.

Equally, it’s possible for a loss making firm to be incredibly financially healthy.

In addition to learning about a firm’s financial health, the FCF also allows investors to see if a firm has enough cash flow available to fund future activities.

Companies have to continue growing to expand their ability to generate not only revenues but also cash flow.

The way that investors typically check to see if a company can keep expanding is by looking at their bottom-line net income.

However, this is far from prudent. That’s because, as we highlighted earlier, the profitability of a firm doesn’t necessarily say anything about its financial stability.

Net Income is affected by many accounting conventions. As a result, its value doesn’t necessarily reflect the economic reality.

FCF and Financial Health

Investors should want to know not only whether a firm can meet its operational expenses, but also:

• whether bond and debt payments to them can continue
• whether dividends can continue to be paid out sustainably, and
• if other debt obligations can continue to be covered.

If a firm fails to meet its debt obligations, it can be forced into liquidation/insolvency or bankruptcy.

At the risk of sounding obvious, this is terrible news for everyone involved in the business (both internal and external stakeholders).

If a company has plenty of excess free cash flow however, they will have more flexibility in difficult times.

These companies will be able to invest in new projects with ease.

And they’ll also be attractive to employees and prospective employees due to better stability.

All of these things mean that a company can grow sustainably. And growth is critical to share prices.

Thus, all of this is to say that investors should prefer to see free cash flow to make sure that a company is genuinely financially healthy.

Where Is Free Cash Flow On a Financial Statement?

Free Cash Flow isn’t typically found on any financial statement explicitly.

Instead, it’s a value / metric that’s calculated by using a variety of figures across different financial statements.

You can calculate FCF using either:

• the Cash Flow Statement and the Statement of Income (aka Income Statement), or
• the Cash Flow Statement only.

The choice of which statement(s) you use is ultimately a function of how you want to calculate FCF.

This brings us to the next part of this article.

How To Calculate Free Cash Flow

There are 2 main ways of calculating Free Cash Flow. The differences mainly arise from which profit you choose to work with.

Calculate FCF using Operating Profit

In general, FCF is calculated by starting with the operating profit (aka EBIT) as…

   

Where:

• denotes Free Cash Flow as before
• refers to Earnings Before Interest and Tax
• represents the corporate tax rate
• denotes Non Cash Expenses (e.g., depreciation, amortisation, etc)
• reflects the change in working capital, and
• represents the Capital Expenditure

This is the same formula we saw earlier towards the beginning of this article.

It starts with which you can think of as the operating profit after tax.

By multiplying by we’re essentially getting to the Earnings After Tax (but before Interest expense).

To reverse the effects of accrual accounting, we add back non-cash expenses () like depreciation, amortisation, impairments, etc.

We then subtract changes in working capital, which itself is estimated as:

.

Put simply, represents the difference between the Net Current Assets over two time periods.

Finally, we subtract the (or Capital Expenditure), which is essentially investments in Non-Current Assets.

Calculate FCF using Net Profit

Sometimes, people might choose to start with Net Profit instead of Operating Profit when calculating FCF.

In such instances, you would essentially work with a modified FCF formula; something like this:

   

Here, by starting with the Net Income and adding back interest, we’re essentially going back to .

Not quite the same. But pretty close nevertheless.

It’s not quite the same because in the case with , the tax is being charged on .

When we start with Net Income and add back the interest expense however, the tax would’ve likely been charged on the (or Earnings Before Tax).

Of course, we can make further adjustments to the Net Income based formula for FCF and arrive at something closer to .

But that’s not the point nor focus of this article.

The point is, there are different ways of calculating FCF. But the underlying result is largely the same across all variants…

It gets us to a cash flow that’s freely available to distribute to debt and equity investors.

Free Cash Flow Calculation Example

Consider Roofers Inc., which recently reported $400m in operating profit. The firm’s depreciation expense for the year was equal to $30m, all of which related to its tangible non-current assets worth $800m of which $300m was in the most recent financial year itself.

Financial statements of the company reported an increase in net working capital of $42 million to $148 million as of the most recent reporting date. The company’s corporation tax rate is equal to 20%.

What is Roofers Inc.’s FCF?

Go ahead and try working it out on your own! There are a few red herrings in the questions so do watch out!

Free Cash Flow Calculation Example (Solution)

Let’s go ahead and solve this together now.

Recall that the expanded FCF formula is expressed as…

   

Where:

• denotes Free Cash Flow as before
• refers to Earnings Before Interest and Tax
• represents the corporate tax rate
• denotes Non Cash Expenses (e.g., depreciation, amortisation, etc)
• reflects the change in working capital, and
• represents the Capital Expenditure

In this instance, we’re told that the Operating Profit is $400 million. This is the firm’s .

We’re told that the firm’s Net Working Capital increased by $42 million which is .

in this instance is the depreciation expense of $30m.

Finally, the equates to $300m since that’s the investment in non-current assets for the year.

Now it’s just a simple case of plugging in the numbers into the formula for FCF:

   

Solving for that gives us…

   

Notice the stark difference between the firm’s profit (strictly, operating profit) and FCF.

$400 million in EBIT, and ‘just’ $8m in FCF!

Importantly, just because the FCF is significantly lower than the profit doesn’t mean this is a “bad”/”poor” company.

Notice that, in this example, the FCF largely decreases because of CAPEX.

CAPEX represents a firm’s investment in assets for the long-term. Assuming those assets generate future economic benefit, they may well drive greater FCF for the firm in the future.

What Are The Limitations of FCF?

While FCF is perhaps one of the strongest financial figures of them all, it’s not without limitations.

The impact of CAPEX in particular can mean FCF is quite a “lumpy” figure, generally not anywhere near as ‘smooth’ as say, Net Income.

We’d argue that this is a strength, though, in that it better reflects the economic reality.

The real-world is often lumpy, too. But investors tend to prefer “smooth” growth trajectories vs lumpy ones.

And this is perhaps why the FCF’s “lumpy” nature is often regarded as a limitation.

The somewhat ‘complex’ nature of the FCF does make it a little bit harder for some people to understand. Especially when one compares it to the relative simplicity of calculating Net Profit.

But whether you’re a fundamental investor, a technical analyst, or a data-driven investor, we reckon it’ll hold you in good stead to know and fully understand FCF.

Wrapping Up

In summary, Free Cash Flow represents the cash flow that’s freely available to distribute to debt as well as equity investors.

It’s the cash flow that’s available to either pay out to investors or reinvest back into the business.

The latter option means FCF can be seen as an excellent representation of a company’s capital available for growth.

Though it has its limitations, investors would do well to prefer it to net income because it shows the ability to pay investors and provide a buffer in the event of a downturn in the market.

Huge free cash flow is also an important figure in mergers and acquisitions.

Large FCF figures may help protect a company from hostile takeovers in some cases, for example.

Alright, that’s a wrap from us for now. We hope you found this article useful.

Keep learning, keep growing!