Definition
The financial investing term free cash flow refers to the money a company is able to generate after subtracting the costs necessary to maintain and expand the business. Free cash flow (FCF) is a metric that's closely tracked by both the company's financial decision makers as well as investor-analysts.
Calculation
Free Cash Flow (FCF) = Operating Cash Flow - Capital Expenditures
Where:
Operating Cash Flow = EBIT x (1 - Tax Rate) + Depreciation + Amortization - Change in Net Working Capital
Explanation
The cash a company generates allows it to pay for its operating expenses, return money owed to lenders, and expand its business. Also referred to as FCF, free cash flow is considered by many investor-analysts to be a superior measure to net income, since it's more difficult to manipulate through less-than-reputable accounting practices. For example, an income statement may indicate the company is generating profits; if it runs out of cash, however, the company may wind up in a bankruptcy proceeding.
Free cash flow takes the company's operating cash flow and adjusts it for capital expenditures. For this reason, analysts must evaluate free cash flow along with the company's reserve of cash. While it's desirable for FCF to be a positive number, companies can have a negative value if they're making large capital investments. For example, an increase in the demand for a company's product can result in large capital expenditures to expand production capacity. In this example, an increase in the company's future profits would justify a near-term decrease in cash reserves. Free cash flow can also decrease when there is an increase to working capital, which is the money a company sets aside to pay for its short term operating expenses.
Another way to view cash flow is this: It's the money available to shareholders and lenders; since these funds would be used to pay bondholders or dividends to owners of common stock. Finally, the calculation of FCF excludes non-cash expenses such as depreciation and amortization. It's also a metric that uses information from both the income statement as well as the balance sheet.
Example
Company A's income statement indicates EBIT of $15,550,000, which includes a depreciation expense of $3,250,000. Company A's balance sheet indicates a year-over-year decrease in working capital of $2,000,000, while fixed assets grew by $5,000,000. Company A's effective tax rate is 40%.
The operating cash flow for Company A would be calculated as follows:
= $15,550,000 x (1 - 0.40) + $3,250,000 - $2,000,000 = $9,330,000 + $3,250,000 - $2,000,000 = $10,580,000
While free cash flow for Company A would be calculated as follows:
= $10,580,000 - $5,000,000, or $5,580,000
Related Terms
The income statement is a financial accounting report that demonstrates how net income, or profit, is derived from revenues. The main categories appearing on an income statement include revenues, cost of goods sold, operating expenses, non-recurring items and net income.
Moneyzine EditorJanuary 22nd, 2024- The financial accounting term working capital is used to describe the excess of current assets when compared to current liabilities. The relative size of a company's working capital is an indication of the short-term financial strength of the company.Moneyzine EditorSeptember 21st, 2023
- The financial accounting term net Income is used to describe a measure of a company's profitability. Net income is a line item appearing on the income statement, and is derived by subtracting expenses from revenues.Moneyzine EditorSeptember 20th, 2023
The cash flow statement is a financial accounting report that demonstrates how cash flows both into and out of a company. Cash flow statements provide investors and analysts with insights into the change in cash and cash equivalents in a given accounting period.Moneyzine EditorJanuary 10th, 2024
The financial accounting term depreciation is sometimes defined as a decline in tangible plant's service potential. Depreciation is a method of allocating the cost of a tangible asset in a systematic manner to those time periods that benefit from the use of the asset.Moneyzine EditorJanuary 16th, 2024
The accounting term used to describe the expiration of intangible assets such as patents or goodwill is amortization. As is the case with the depreciation of a tangible asset, the amortization of an intangible asset is shown on the income statement as an expense of the company; thereby reducing net income over the years this benefit is realized.Moneyzine EditorJanuary 5th, 2024- The financial investing term operating cash flow refers to the money a company is able to generate through normal business operations. Operating cash flow (OCF) is a metric that's closely tracked by both the company's financial decision makers as well as investor-analysts.Moneyzine EditorSeptember 20th, 2023
The term cash flow per share is used to describe a profitability metric that divides a company's cash flow by the number of common shares outstanding. Cash flow per share is thought to be a better measure of a company's ability to generate profits than earnings per share.Moneyzine EditorJanuary 10th, 2024
The term free cash flow per share is used to describe a profitability metric that divides a company's free cash flow by the number of common shares outstanding. Free cash flow per share is thought to be the premier measure of a company's financial flexibility, which is their ability to react to unexpected expenses and investment opportunities.Moneyzine EditorJanuary 18th, 2024
