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What is Free Cash Flow?
Free Cash Flow (FCF) refers to the cash that companies or businesses generate after reducing cash flows related to capital assets maintenance from their operational cash outflows. A company’s FCF can provide various details about its performance. Most importantly, it is an indicator of a company’s cash profitability by excluding any non-cash expenses.
In other words, Free Cash Flow shows the amount of cash a company generates after removing reinvestment in capital assets. Calculating and understanding the concept of FCF can be crucial for both companies and investors. For companies, it results in better cash management. For investors, on the other hand, it helps provide insights into a company’s financial performance.
What is the Free Cash Flow formula?
There are various formulas used to calculate a company’s Free Cash Flow. However, all of them will provide the same result. Based on the available information, investors or companies can use any of these formulas.
Formula # 1
The first Free Cash Flow formula calculates the amount by using a company’s operating cash flow. This method is straightforward and does not include any complicated calculations. The information required to calculate Free Cash Flow through this formula is readily available from a company’s financial statements.
This formula takes a company’s operating cash flows and reduces any capital expenditure from the amount. Mathematically, it is as below.
Free Cash Flow = Operating Cash Flow – Capital Expenditure
Formula # 2
Users can also calculate a company’s Free Cash Flow from its net operating profits. The information required for this formula is available in a company’s Income Statement and Balance Sheet. This formula removes a company’s net investment in operating capital from its net operating profits after taxes. Therefore, it will be as follows.
Free Cash Flow = Net Operating Profit After Taxes – Net Investment in Operating Capital
The net investment in operating capital represents the sum of the net operating working capital and net property, plant, and equipment.
Formula # 3
Lastly, users can also use another formula to calculate a company’s Free Cash Flow. However, this formula is relatively more complex. This formula starts from a company’s revenues and removes any associated costs to reach its Free Cash Flow. The information required for this calculation is available in a company’s Income Statement and Balance Sheet.
Mathematically, the formula can be written as below.
Free Cash Flow = Revenues – Operating Costs – Taxes – Required Investments in Operating Capital
The required investments in operating capital is the difference between a company’s total net operating capital between two years.
Example
A company, Red Co., reported cash flow from operating activities of $100,000 in its Cash Flow Statement. The company also incurred a capital expenditure of $20,000 in the same accounting period. Therefore, Red Co.’s Free Cash Flow will be as follows.
Free Cash Flow = Operating Cash Flow – Capital Expenditure
Free Cash Flow = $100,000 – $20,000
Free Cash Flow = $80,000
Conclusion
Free Cash Flow represents the leftover cash after deducting a company’s capital expenditures from its operating cash flows. FCF is crucial for companies and investors alike. These represent cash flows that companies can use in various activities. These activities may include expanding operations, paying off loans, paying shareholders, investing in projects, etc.
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