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Free cash flow

Free cash flow is the cash a company produces from its operations less the cost of expanding its asset base. It is essentially the money that the company could return to shareholders if the company was to grow no further.

Expanded Definition

The simplest way to calculate free cash flow (FCF) is by using the cash flow statement to get both the cash flow from operations and the capital expenditures. The former is the last number of the first section, while the latter is usually the first or second item in the following (financing) section.

<math>FCF = cash\ flow\ from\ operations - capital\ expenditures</math>

One synonym for capital expenditures is "purchase of plant, property, & equipment." Even though this is a negative number, do not subtract the negative (net result of adding "capex" to cash from operations). FCF will always be smaller than cash from operations.

Because free cash flow is a non-GAAP financial measure, companies that use this metric are required to disclose how it is calculated.

Free Cash Flow vs. Net Income

Free cash flow is used by some instead of (or in conjunction with) net income as a measure of a company's profitability. As its name implies, free cash flow is calculated on a purely cash basis whereas net income is calculated on an accrual basis in accordance with generally accepted accounting principles(GAAP).

Let's take the treatment of capital expenditures to illustrate the difference between free cash flow and net income. Suppose a company has $1000 of net income every single year, before depreciation. One year, the company buys a truck for $1000 to help in deliveries. In the year of purchase, and assuming everything else came to zero, FCF for that year would be $1000 cash from operations (in this case, equal to net income) minus $1000 capital expenditure (the truck) equal to $0.

The truck will be depreciated over 4 years at $250 per year. So, for the next four years, net income would be only $750. Cash from operations, though, would be $1000 because depreciation is added back in. Capital expenditures would be zero. So for those 4 years, FCF is $1000.

For the 5 years of this example, here is how net income and FCF compare:

Year Net income FCF
1 $1000 $0
2 $ 750 $1000
3 $ 750 $1000
4 $ 750 $1000
5 $ 750 $1000
Total $4000 $4000

For free cash flow purposes, the amount paid on the truck is subtracted out as a capital expenditure in the first year. However, the cost of the truck is depreciated over its useful life for net income purposes. As you can see, over the long run, free cash flow and net income should roughly equal each other, but over the short term there will be timing differences.

Arguments for and against

Proponents of free cash flow argue that free cash flow is harder to manipulate than net income since it isn't subject to accounting shenanigans. However, free cash flow can also be manipulated by delaying items such as capital expenditures.

Another argument in favor is that it's possible to have positive net income but negative free cash flow. Without free cash flow (or financing), a company can't pay its bills and is in danger of bankruptcy.

An argument in favor of net income is that it's smoother than free cash flow. Since capital expenditures are frequently lumpy, free cash flow can often jump around from year to year. Of course, free cash flow and net income do not have to be an either/or proposition. They can be used in conjunction with each other to identify problem areas. By analyzing the differences between the two, investors can gain useful insights.

More complicated ways to calculate

Free cash flow to the firm (FCFF)

This measures how much cash is available for all claim holders in the firm (debt holders and share holders) after all taxes and needs for reinvestment have been met.

FCFF = EBIT(1 - tax rate) - CapEx + Depreciation - Change in non-cash working capital

This starts with operating profit and then subtracts tax so that it does not include the tax benefit from paying interest. In other words, this pretends that there is no interest expense or tax benefit from that interest expense.

Positive FCFF means that there is cash to either service debt (through interest payments or principal repayments) and / or service the equity holders (through dividends or share repurchases).

Negative FCFF means that the firm will have to raise more cash, either through issuing more debt or selling more equity.

Free cash flow to equity (FCFE)

This measures how much cash is available to equity holders (shareholders) after tax needs, debt needs, and growth needs have been met.

FCFE = Net income - CapEx + Depreciation - Change in NCWC - Debt repaid + Debt issued

Debt is a source of cash for equity holders, so this calculation includes that. When positive, it shows what can be paid out to equity holders (as a dividend or repurchased stock) without doing any damaging the firm's operations or growth opportunities. When negative, it implies that the firm must issue new equity to raise cash.

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