Free cash flow is the cash a company produces through its operations, less the cost of expenditures on assets. In other words, free cash flow or FCF is the cash left over after a company pays for its operating expenses and capital expenditures or CAPEX.

Free cash flow is an important measurement since it shows how efficient a company is at generating cash. Investors use free cash flow to measure whether a company might have enough cash, after funding operations and capital expenditures, to pay investors through dividends and share buybacks.

Calculating Free Cash Flow

To calculate FCF, from the cash flow statement, we'll find the item cash flow from operations (also referred to as "operating cash" or "net cash from operating activities") and subtract capital expenditure required for current operations from it. 

The Free Cash Flow formula is:

Example of Free Cash Flow

Macy's Inc. (M)

Below is Macy's cash flow statement for the fiscal year ending 2017 according to the company's 10K statement.

Macy's recorded the following:

  • Cash flow from operating activities = $1.944 billion
  • Capital expenditures - $760 million
  • Macy's FCF = $1,944 - $760 = $1.184 billion
1:19

Unlevered Free Cash Flow

Interpreting Free Cash Flow

We can see that Macy's had a large amount of free cash flow, which can be used to pay dividends, expand operations, and deleverage its balance sheet, i.e. reduce debt.

Please note the $411 million credit from the sale of property and equipment listed under Cash Flows from Investing Activities was not included since it's a one-time event and not part of everyday cash flow activities. 

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 buy backs, 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 soon be heading up.

By contrast, shrinking FCF might signal that companies are unable to sustain earnings growth. An insufficient FCF for earnings growth can force a company to boost its debt levels or not have the liquidity to stay in business.

To calculate free cash flow another way, you'll need the income statement and balance sheet. Start with net income and add back charges for depreciation and amortization. Make an additional adjustment for changes in working 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 Captial 
- 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.

Bottom Line

One drawback to using the free cash flow method is that capital expenditures can vary dramatically from year to year and between different industries. That's why it's critical to measure FCF over multiple periods and against the backdrop of the company's industry. 

It's important to note that an exceedingly high FCF might be an indication that the company is not investing in their business properly such as updating their plant and equipment. Conversely, negative FCF might not necessarily mean a company is in financial trouble, but rather, investing heavily in expanding their market share which would likely lead to 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 that future growth is likely.