Free cash flow (FCF) is a financial metric that measures a companys ability to generate cash thats available to be distributed in a discretionary way. It represents the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet.
Free cash flow can be calculated in various ways, depending on the audience and available data. A common measure is to take the earnings before interest and taxes, add depreciation and amortization, and then subtract taxes, changes in working capital, and capital expenditure. Unlevered free cash flow (i.e., cash flows before interest payments) is defined as EBITDA - CAPEX - changes in net working capital - taxes. If there are mandatory repayments of debt, then some analysts utilize levered free cash flow, which is the same formula as above, but less interest and mandatory principal repayments.
Free cash flow is an important financial metric because it represents the actual amount of cash at a company’s disposal. A company with consistently low or negative FCF might be forced into costly rounds of fundraising in an effort to remain solvent. Knowing a companys free cash flow enables management to decide on future ventures that would improve shareholder value. Additionally, having an abundant FCF indicates that a company is capable of paying its monthly dues and can use its FCF to expand business operations or pursue other short-term investments.
The formula for FCF is: Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures. CFO is net income plus any non-cash expenses, adjusted for changes in non-cash working capital (accounts receivable, inventory, accounts payable, etc) . The company’s net income greatly affects its free cash flow because it also influences the company’s ability to generate cash from operations.
