Free cash flow (FCF) is the cash a company generates 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 company pays for its operating expenses and capital expenditures (CapEx). It 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 and will provide investors with insight into a company's financials, helping them make better investment decisions.
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 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 free cash flow number to choose good investments that will generate a return on your capital.
- Free cash flow (FCF) is the money a company has left over after paying its operating expenses and capital expenditures.
- 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), the debt-to-equity ratio, and earnings per share (EPS).
How to Calculate Free Cash Flow
There are three different methods to calculate free cash flow because all companies don't have the exact same financial statements. Regardless of the method used, the final number should be the same given the information a company provides. The three ways in which 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 item cash 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:
Free Cash Flow= Operating Cash Flow −Capital Expenditures
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 selling, general, and administrative costs (SG&A).
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:
Free Cash Flow=Sales Revenue −(Operating Costs + Taxes) −Required Investments in Operating Capitalwhere:Required Investments in Operating Capital=Year One Total Net Operating Capital −Year Two Total Net Operating Capitaland where:Total Net Operating Capital=Net Operating Working Capital +Net Plant, Property, and Equipment(Operating Long-Term Assets)and where:Net Operating Working Capital=Operating Current Assets −Operating Current Liabilitiesand where:Operating Current Assets=Cash +Accounts Receivables+InventoryOperating Current Liabilities=Accounts Payables +Accruals
Using Net Operating Profits
To calculate free cash flow using net operating profits after taxes (NOPAT) is similar to the calculation of using sales revenue, but where operating income is used.
The formula is:
Free Cash Flow=Net Operating Profit After Taxes −Net Investment in Operating Capitalwhere:Net Operating Profit After Taxes=Operating Income ×(1 - Tax Rate)and where:Operating Income=Gross Profits−Operating Expenses
The calculation for net investment in operating capital is the same as described above.
Example of Free Cash Flow Calculation
Macy's Inc. (M)
Cash Flow From Operating Activities = $1.608 billion
Capital Expenditures = $1.157 billion
Free Cash Flow=$1.608 billion−$1.157 billion=$450 million
Interpreting Free Cash Flow
From 2017 till 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 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 companies to boost debt levels or not have the liquidity to 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 flow another way, locate 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):
|- 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.
Free Cash Flow Benefits
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 is able to pay its debts, contribute to growth, share its success with its shareholders through dividends, and has prospects for a successful future.
Free Cash Flow Limitations
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 a company's industry.
It's important to note that an exceedingly high FCF might be an indication that a company is not investing in its business 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 expanding its market share, which would likely lead to future growth.
How to Calculate Free Cash Flow FAQs
How Do You Calculate Free Cash Flow?
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 but instead 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 income statement and subtracting it from 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 versus 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 ratio, and earnings per share (EPS).
U.S. Securities & Exchange Commission. "Form 10-K, Macy's Inc," Pages 19 and F-10. Accessed Jan. 15, 2021.