Free cash flow (FCF) is the cash a company has left over after paying all of its expenses, including capital expenditures. As a financial metric, FCF shows how much cash is genuinely available for reinvestment, paying dividends, or reducing debt.
What does free cash flow mean?
It means the real cash left after a company covers its operating costs and capital spending. It represents the unencumbered cash available for discretionary use without impacting essential operations.
FCF gives you a more realistic idea of your company’s financial health and profitability than just earnings. And it’s distinct from net income because it’s about actual cash movements instead of accounting profits.
What is the free cash flow formula?
All you need to do is subtract capital expenditures from operating cash flow:
Free cash flow = Operating cash flow – Capital expenditures
Operating cash flow is part of a company’s cash flow statement. It details the cash made from the business’s core operations. CapEx represents the money a business spends on machinery, equipment, infrastructure, etc.
Free cash flow can also be calculated using net income by adjusting for non-cash expenses and changes in working capital. These working capital adjustments account for non-cash working capital like receivables and payables.
What is operating cash flow?
Operating cash flow is the money generated or used in a business’s main activities (i.e. the sale of goods and services). It shows a business’s ability to generate cash from regular operations.
To find your operating cash flow, start with net profit and add back non-cash items like depreciation. Then adjust for changes in current assets like accounts receivable, plus accounts payable and net working capital.
What do positive and negative free cash flow mean?
Positive free cash flow is an indicator that a company earns more than it spends. A high free cash flow allows businesses to survive economic downturns, make strategic acquisitions, return value to shareholders, or pursue other positive business strategies.
Negative free cash flow, on the other hand, shows a business spends more than it earns. But this doesn’t always signal trouble – high-growth companies and startups might spend heavily on capital assets to fuel future growth. What matters is whether they can generate enough cash later.
Why free cash flow matters
Free cash flow matters because it shows a company’s ability to make money beyond its operational needs.
Investors use FCF to assess a company’s ability to grow, pay down debts and pay dividends. They usually prefer companies with strong, stable free cash flow because it’s a sign of good financial health and the ability to sustain operations independently.
Here’s why it matters:
- Strong free cash flow lets a company invest in growth, return value to equity investors or manage debt.
- FCF is a very useful measure of a company’s ability to repay creditors and minimise financial risk and interest expense over time.
- Free cash flow is used in discounted cash flow (DCF) models to figure out the intrinsic value of a company.
- Consistent positive FCF provides the extra cash needed to take advantage of opportunities without outside financing.
What are the types of free cash flow?
Levered free cash flow accounts for cash flow after interest payments on debt. Unlevered free cash flow ignores interest payments for a greater overview of operational performance.
Two related measures are also used in corporate finance. Free cash flow to equity (FCFE) shows the cash available to shareholders after all operational expenses and debts. Free cash flow to the firm (FCFF) considers cash available to all capital providers, including equity and debt holders.
How can you improve free cash flow?
Improving free cash flow is as simple (or not-so-simple) as increasing operating cash flow while managing capital expenditures and working capital. Small changes to cash inflows and cash outflows add up over time.
Some strategies include optimising accounts receivable by speeding up collections and offering early payment discounts. Maybe you can manage inventory better by including just-in-time (JIT) systems to avoid tying up cash in unsold stock.
Or perhaps you might be able to delay what the business pays suppliers wherever sensible, and conduct regular expense audits to cut out non-essential spending.
Regular cash flow forecasting will help you anticipate shortages and surpluses and be more financially stable. Ultimately, good cash flow management is central to any financial strategy.
How is free cash flow different from profit?
FCF covers actual cash movement, while profit is an accounting measure influenced by all sorts of things. Free cash flow gives you a more raw and realistic picture of your company’s operational success and ongoing sustainability.
For all these reasons, FCF is essential during financial analysis. Knowing your company’s financial performance means looking at real cash, not just profit margins on paper. For a small business owner, that’s the difference between looking profitable and actually having cash in the bank.
How do you track free cash flow?
Track your company’s free cash flow using your income statement, balance sheet, and cash flow statement. It’s a good idea to use accounting software to generate your financial statements and monitor cash flow automatically.
Strong free cash flow gives your business the flexibility to grow while meeting all its financial obligations — without needing to raise money through debt financing or equity investors.
See related terms
What is cash flow?
What is working capital?
What is marginal cost?
What are fixed assets?
