A:

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

## 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 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.

## 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.

RELATED FAQS
1. ### Free & operating cash flows: What's the Difference?

Learn the difference between free cash flow and operating cash flow. Explore how analysts use earnings and cash flow to evaluate ... Read Answer >>
2. ### What are some examples of how cash flows can be manipulated or distorted?

Read about some of the most common accounting techniques that can be used to manipulate the operating cash flow on a company's ... Read Answer >>
3. ### Are taxes calculated in operating cash flow?

Learn how taxes are involved with the calculations for a firm's operating cash flow, and the overall significance of operational ... Read Answer >>
4. ### How should I evaluate a company with negative cash flow investing activities?

Negative cash flow from investing activities should be evaluated since it could be a warning sign. However, it can also mean ... Read Answer >>
5. ### What is the formula for calculating free cash flow in Excel?

Find out more about free cash flow, the formula for calculating free cash flow and how to calculate a company's free cash ... Read Answer >>
6. ### What is the difference between cash flow and fund flow?

See how cash flow and fund flow differ from each other, and why fund flow can be used very differently by accountants and ... Read Answer >>
Related Articles
1. Investing

### Free Cash Flow: Free, But Not Always Easy

Free cash flow is a great gauge of corporate health, but it's not immune to accounting trickery.
2. Investing

### Analyze cash flow the easy way

Learn the key components of the cash flow statement, how to analyze and interpret changes in cash, and what improved free cash flow means to shareholders.
3. Retirement

### Picking Retirement Stocks: Dividends vs. Free Cash Flow

Instead of focusing on dividend payments, a better metric for choosing stocks for your retirement portfolio could be a company’s free cash flow (FCF).
4. Investing

### Corporate Cash Flow: Understanding the Essentials

Tune out the accounting noise and see whether a company is generating the stuff it needs to sustain itself. Learn how to read the cash flow statement.
5. Tech

### Cash Flow Is King: How to Keep it Running

Why is cash flow so important, and what steps can a business take to improve it?
6. Investing

### What Is a Cash Flow Statement?

The Cash Flow Statement measures whether a company generates enough cash to meet its operating expenses.

### Understanding Cash Flow

Learn about the different types of cash flows and the importance for businesses to properly manage their cash flows.
8. Investing

### Cash Flow Indicator Ratios

Learn about the operating cash flow to sales ratio, free cash flow to operating cash flow ratio and free cash flow coverage ratio.
RELATED TERMS
1. ### Cash Flow

Cash flow is the net amount of cash and cash-equivalents being ...
2. ### Free Cash Flow Yield

Free cash flow yield is a financial ratio that standardizes the ...
3. ### Free Cash Flow - FCF

Free cash flow represents cash a company can generate after accounting ...
4. ### Cash Flow From Operating Activities (CFO)

Cash Flow From Operating Activities (CFO) is an accounting item ...
5. ### Operating Cash Flow Ratio

The operating cash flow ratio is a measure of how well current ...
6. ### Cash Flow From Financing Activities

Cash flow from financing activities is a category in a company’s ...
Hot Definitions
1. ### Diversification

Diversification is the strategy of investing in a variety of securities in order to lower the risk involved with putting ...
2. ### Intrinsic Value

Intrinsic value is the perceived or calculated value of a company, including tangible and intangible factors, and may differ ...
3. ### Current Assets

Current assets is a balance sheet account that represents the value of all assets that can reasonably expected to be converted ...
4. ### Volatility

Volatility measures how much the price of a security, derivative, or index fluctuates.
5. ### Money Market

The money market is a segment of the financial market in which financial instruments with high liquidity and very short maturities ...
6. ### Cost of Debt

Cost of debt is the effective rate that a company pays on its current debt as part of its capital structure.