Free cash flow (FCF) is a measure of the cash generated by a business after accounting for capital expenditures (CAPEX). It is calculated by taking the cash flow from operating activities and deducting the investment in property, plant, and equipment (CAPEX).
Free Cash Flow Formula
The free cashflow formula can be stated as follows.
To calculate FCF, you subtract capital expenditures from the operating cash flow. Operating cash flow is the amount of cash a business generates from its operations. This includes sales revenue, minus the cost of goods sold, operating expenses, and taxes. Capital expenditures include the costs of purchasing and maintaining fixed assets, such as buildings, equipment, and technology.
Strictly speaking the capital expenditure used in the calculation is the amount required to maintain the growth of the business at the current rate. In practice this figure is not generally available, and it is normal to use the total capital expenditure figure in the financial statements.
The purpose of free cash flow is to see what cash is available (free) from the operations of the business after allowing for cash to maintain the current growth rate. This free cash flow is then available to improve growth by taking advantage of expansion opportunities, to invest in new products, and to reduce debt and pay dividends to equity providers. Additionally it also gives investors an idea of how much a business can grow without relying on external financing.
Free Cash Flow Calculation
If we look at the basic cash flow statement below, the highlighted elements represent the main components of free cashflow of the business.
| Net income | 50,000 |
| Add back depreciation | 12,000 |
| Working capital | -5,000 |
| Operating activities | 57,000 |
| Capital expenditure | -30,000 |
| Investing activities | -30,000 |
| Debt repayments | -10,000 |
| New debt | 26,000 |
| New capital | 12,000 |
| Financing activities | 28,000 |
| Net cash flow | 55,000 |
| Opening cash balance | 10,000 |
| Closing cash balance | 65,000 |
In the above free cashflow example, the operating cash flow is 57,000, and the amount spent on capital expenditure is 30,000.
The free cash flow is calculated by deducting the capital expenditure from the operating cash flow as follows.
Free cash flow = Operating cash flow - Capital expenditure Free cash flow = 57,000 - 30,000 = 27,000
Our free cash flow calculator is available to help you carry out the calculation.
Conclusion
In summary, by analyzing the FCF of a business, investors can gain valuable insights into its growth prospects, cash flow management, and potential for generating returns.
When a business has positive FCF, it means that it is generating more cash than it needs to maintain and grow its business. Positive FCF is a good indicator of financial strength. In contrast, negative FCF can be a warning sign that a busines is not generating enough cash to support its operations and growth.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.