The free cash flow calculation tells a company how much cash it is generating after paying the costs of remaining in business. In other words, it lets business owners know how much money they have to spend at their discretion. It's a key indicator of a company's financial health and desirability to investors.
Here's how to calculate free cash flow, and why it matters to both businesses and investors.
What Is Free Cash Flow?
Free cash flow refers to how much money a business has left over after it has paid for everything it needs to continue operating—including buildings, equipment, payroll, taxes, and inventory. The company is free to use these funds as it sees fit.
Businesses calculate free cash flow to guide key business decisions, such as whether to expand or invest in ways to reduce operating costs. Investors use free cash flow calculations to check for accounting fraud—these numbers aren't as easy to manipulate as earnings per share or net income. Free cash flow also gives investors an idea of how much money could possibly be distributed in the form of share buybacks or dividend payments.
How Do You Calculate Free Cash Flow?
There are several ways to calculate free cash flow, but they should all give you the same result. Not all companies make the same financial information available, so investors and analysts use the method of calculating free cash flow that fits the data they have access to. The simplest way to calculate free cash flow is to subtract a business's capital expenditures from its operating cash flow.
If you're analyzing a company that doesn't list capital expenditures and operating cash flow, there are similar equations that determine the same information, such as:
- Free cash flow = sales revenue - (operating costs + taxes) - required investments in operating capital
- Free cash flow = net operating profit after taxes - net investment in operating capital
How Free Cash Flow Works
Positive free cash flow is indicative of overall business health. Companies that have a healthy free cash flow have enough funds on hand to meet their bills every month—and then some. A company with rising or consistently high free cash flow is generally doing well and might want to consider expanding. A company with falling or consistently low free cash flow might need to restructure because there's little money remaining after covering the bills.
It's not unusual for investors to look for companies with rapidly rising free cash flow because such companies tend to have excellent prospects. If investors find a company with rising cash flow and an undervalued share price, it is a good investment and maybe even an acquisition target.
Limitations of Free Cash Flow
Low free cash flow is not always indicative of a failing business. Even healthy companies see a dip in free cash flow when they're actively pursuing growth. Corporate moves like acquisitions and investments in new product development temporarily subtract from the bottom line.
Try to look beyond the numbers. Keep in mind that older, more established companies tend to have more consistent free cash flow, while new businesses are typically in a position where they're pouring money into stabilization and growth. The company's industry also plays a large role in determining free cash flow—not every business needs to spend money on equipment, land, or inventory.
Free cash flow is a better indicator of corporate financial health when measuring nonfinancial enterprises, such as manufacturing or service firms, rather than investment firms or banks. It all depends on the kinds of fixed assets that are required to operate in a given industry.
Though more foolproof than some other calculations, free cash flow is not completely immune to accounting trickery. Regulatory authorities haven't set a standard calculation method, so there is some wiggle room for accountants. For example, accounts can manipulate when accounts receivable and accounts payable are received, made, and recorded to boost free cash flow.
- Free cash flow measures how much cash a company has at its disposal, after covering the costs associated with remaining in business.
- The simplest way to calculate free cash flow is to subtract capital expenditures from operating cash flow.
- Analysts may have to do additional or slightly altered calculations depending on the data at their disposal.
- Free cash flow is best used to analyze nonfinancial companies with clear capital expenditures such as warehouses, inventory, and manufacturing equipment.