Understanding Free Cash Flow: What is it and How To Calculate

understanding free cash flow

What is free cash flow (FCF)?

Free cash flow (FCF) is a financial metric that quantifies the amount of cash a business generates after accounting for capital expenditures. Capital expenditures, often abbreviated as CapEx, include investments in long-term assets like buildings, machinery, and equipment.

In simpler terms, free cash flow is the cash left over after a company has paid all its bills and made necessary investments for future growth. It’s a key indicator for investors, creditors, and other stakeholders, as it reveals the company’s ability to generate value and sustain operations.

Why is free cash flow important?

Calculating free cash flow is crucial for a variety of reasons, each contributing to a more nuanced understanding of a company’s financial health and long-term viability. Here are some key reasons why free cash flow is important:

  1. Investor confidence: A positive free cash flow can boost investor confidence as it indicates a financially stable company that can generate surplus cash. This often makes the company’s stock more attractive to investors.
  2. Business growth: Companies with a healthy free cash flow have the financial flexibility to invest in new projects, research and development, and other growth opportunities without relying on external financing.
  3. Debt repayment: A strong free cash flow enables a company to pay down its debts more easily, reducing its financial risk and making it more attractive to both creditors and investors.
  4. Dividend payments: Companies that generate a consistent and growing free cash flow are more likely to pay dividends to shareholders, thereby increasing shareholder value.
  5. Financial planning: Understanding free cash flow can help businesses plan for the future, including capital allocation for various projects and potential mergers or acquisitions.
  6. Risk assessment: A negative or declining free cash flow could be a warning sign of underlying problems in a company, such as declining sales or increasing costs, and warrants further investigation.

Types of free cash flow

Free cash flow is not a one-size-fits-all metric. Depending on what you’re looking to understand or analyze, there are different types of free cash flow:

  1. Free cash flow to the firm (FCFF): This is the cash available to all capital providers, including both debt and equity holders. It is calculated before interest payments and is often used in valuation models like the Discounted Cash Flow (DCF) analysis.
  2. Free cash flow to equity (FCFE): This is the cash available strictly to equity holders (shareholders) after all expenses, including debt repayments, have been made. It is often used to assess a company’s ability to pay dividends or buy back shares.
  3. Levered free cash flow: This version of free cash flow accounts for interest payments on debt, making it particularly useful in leveraged buyouts or when assessing companies with significant debt loads.
  4. Unlevered free cash flow: This is free cash flow calculated before interest payments and is often used in corporate finance and valuation.

Each type of free cash flow serves a specific purpose and is useful for different kinds of financial analysis. By understanding these types, businesses and investors can make more informed decisions.

How to calculate free cash flow

Calculating free cash flow is a straightforward process, but it does require access to certain financial statements, specifically the cash flow statement and sometimes the income statement. The most commonly used formula for calculating free cash flow is:

Free cash flow (FCF)=Operating cash flow (OCF)−Capital expenditures (CapEx)

Free-Cash-Flow-FCF-formula

Here’s a breakdown of the formula components:

  1. Operating cash flow (OCF): This is the cash generated from the core business operations. You can find this information on the company’s cash flow statement.
  2. Capital expenditures (CapEx): These are the investments made in long-term assets like machinery, buildings, and equipment. This information is also usually available on the cash flow statement.

Simply subtract the capital expenditures from the operating cash flow to get the free cash flow.

Free cash flow calculation example

To illustrate how to calculate free cash flow, let’s consider a hypothetical example:

Company A’s financials

  • Operating cash flow: $100,000
  • Capital expenditures: $20,000

Using the formula, we calculate free cash flow as follows:

Free cash flow (FCF) = $100,000 (Operating cash flow) – $20,000 (Capital expenditures) = $80,000

In this example, Company A has a free cash flow of $80,000. This means that after accounting for its operational expenses and long-term investments, Company A has $80,000 of cash available. This cash can be used for various purposes such as reinvestment in the business, paying down debt, or distributing dividends to shareholders.

Understanding how to calculate and interpret free cash flow can provide valuable insights into a company’s financial health, helping both businesses and investors make more informed decisions.

Operating cash flow vs free cash flow

Operating cash flow (OCF) and free cash flow (FCF) are both important metrics for assessing a company’s financial performance, but they serve different purposes and are calculated differently.

What is operating cash flow?

Operating cash flow is the cash generated from the core business operations of a company. This includes revenue from sales, minus operating expenses like wages, rent, and utilities. OCF does not take into account long-term investments or capital expenditures.

How they differ

  1. Scope: Operating cash flow focuses solely on the operational aspect of a business, such as revenue and day-to-day expenses. Free cash flow, however, goes a step further to include capital expenditures, providing a more comprehensive view of a company’s financial health.
  2. Use cases: OCF is often used to assess the efficiency of a company’s operations, while FCF is used to evaluate a company’s overall financial stability and its ability to generate shareholder value.
  3. Calculation: OCF is a component in the calculation of FCF. The formula for free cash flow is usually:

Free cash flow (FCF)=Operating cash flow (OCF)−Capital expenditures (CapEx)

Benefits of free cash flow

Free cash flow (FCF) offers several advantages as a financial metric, making it a valuable tool for both companies and investors. Here are some key benefits:

  1. Simplicity: The FCF formula is straightforward, making it easy to calculate and understand.
  2. Versatility: FCF is used in various financial analyses, from assessing a company’s health to its valuation through methods like discounted cash flow (DCF).
  3. Investor appeal: A strong FCF is often attractive to investors as it indicates a company’s ability to generate shareholder value.
  4. Strategic planning: Companies can use FCF for better capital allocation, whether it’s for reinvestment, debt repayment, or shareholder returns.
  5. Risk assessment: Positive or growing FCF is generally seen as a sign of lower financial risk, making the company more appealing to creditors and investors alike.

Limitations of free cash flow

While FCF is a valuable metric, it’s not without its limitations:

  1. Short-term focus: FCF is a snapshot of a company’s cash position at a specific time, which may not reflect its long-term financial health.
  2. Capital expenditures: FCF subtracts capital expenditures, which are necessary for growth but can vary significantly year-to-year, potentially skewing the FCF figure.
  3. Non-cash items: FCF does not account for non-cash expenses like depreciation and amortization, which could impact a company’s actual financial standing.
  4. External factors: FCF can be influenced by external conditions like market volatility or economic downturns, which are beyond the company’s control.
  5. Manipulation: Like any financial metric, FCF can be manipulated through accounting practices, making it essential to consider other metrics for a comprehensive analysis.

free cash flow definition

How Brixx can help you

Brixx is a financial forecasting tool designed to simplify complex financial metrics like free cash flow. Here’s how Brixx can be a valuable tool for your financial management:

  1. Automated calculations: Brixx automatically calculates your free cash flow based on your financial data, saving you time and reducing the risk of errors.
  2. Scenario planning: The software allows you to create different financial scenarios to see how various business decisions could impact your free cash flow.
  3. Forecasting: Utilize past performance data to generate accurate forecasts of your future free cash flow, helping you make informed strategic decisions.
  4. Reporting: Brixx offers customizable reporting features, enabling you to generate detailed free cash flow reports that can be shared with stakeholders.
  5. User-friendly interface: The platform is designed to be intuitive, making it easy even for those without a financial background to understand their company’s free cash flow.

By leveraging the capabilities of Brixx, you can gain a deeper understanding of your financial metrics, make data-driven decisions, and ultimately steer your business towards greater financial stability and growth.

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