Free cash flow (FCF) means the amount of cash remaining with the company after paying for its operating costs, inventory and to buy fixed assets. Which means the cash flow from operating activities minus capital expenditures during the financial year.
We can also define free cash flow as the amount of money the company has generated after accounting all cash outflows that support its operations and maintain its capital assets.
Capital expenditure is the money spent on new investments to replace, expand or modernize long term operating assets of the company.
Below in this article, we will show you how to calculate free cash flow and what it indicates. You will also learn why institutional investors consider free cash flow instead of net earnings.
What Free Cash Flow (FCF) indicates?
Cash left with the company after deducting operating and capital expenditures is available for free use.
If free cash flow is negative, then it indicates that the company’s total cash outlays for expenses is more than it’s cash inflow from revenue.
Free cash flow number is not reported on the income statement.
Earnings before interest, tax, depreciation and amortization (EBITDA) is considered as free cash flow by the financial analysts in order to know how efficiently the company can cover its debt service.
Otherwise, the following formula can be used to calculate free cash flow (FCF) of an organization.
Formula used to calculate free cash flow (FCF)
Free cash flow (FCF) is not a line item listed in the income statement, or in any other financial statements. You have to calculate free cash flow by using line items found in the financial statements.
As discussed above, FCF is the money a company has left over after paying its operating and capital expenditures.
Therefore, Free cash flow = net operating profit after tax for the year – capital expenditure made during the year
Above formula is used when you have a company’s cash flow statement. It’s the easiest way to calculate FCF. Both capital expenditure and operating cash flow can be found in the cash flow statement.
We have one more method to calculate free cash flow. Both calculations should give you the same result.
In the second method, you need to take net operating profit after tax from the company’s income statement to calculate free cash flow. Here is the formula used to calculate FCF;
Free cash flow = Net operating profit after tax – net investment in operating capital
Net operating profit after tax = (Gross profit – operating expenses) * (1-tax rate)
Net investment in operating capital = net operating working capital + net plant, property, and equipment
If you don’t have gross profit to calculate net operating profit, then you can use the following formula to calculate FCF.
FCF = Net income after tax + Depreciation and amortization – Change in working capital – Capital expenditures
Why Free cash flow (FCF) is used?
Knowing how to calculate free cash flow helps the company’s management to manage cash effectively. It shows the efficiency of the management in generating cash.
To investors FCF helps to make better investment decisions. They calculate FCF to know whether the company has enough cash to pay debt, invest in opportunities that can enhance its business and reward its shareholders.
Higher free cash flow indicates that the company has more money that can be allocated to paying down debt, dividends, and growth opportunities.
Shrinking FCF might signal that the company is unable to sustain earnings growth. You need to look into the real reason behind the decline in FCF. If shrinking in free cash flow is due to increase in capital expenditure, then it’s a good thing as new investments might increase revenues and profits in the future.
Remember, free cash flow is just one fundamental indicator used to understand a company’s financial health. You need a complete fundamental analysis to understand the financial position.
- Return on investment (ROI)
- Debt to equity ratio (D/E)
- Earnings per share (EPS)
- Price to earnings ratio (P/E)
- Liquidity ratios
- Profitability ratios
- Solvency ratios
- Turnover ratios
Limitations of Free Cash Flow (FCF)
One of the biggest drawbacks of free cash flow is that it’s not a comparable measure.
FCF may increase or decrease year on year depending on how the company has invested in capex. Similarly a company with same profit with less capex might have higher FCF in comparison to a company which has higher capex. Investing heavily on capex might increase the company’s future earnings, profit and market share.
Now you know what free cash flow is, how to calculate and interpret it. If you like this article, don’t forget to share it and subscribe to our newsletter.