Business Advice

What is free cash flow and how is it calculated?

By November 8, 2023 Reading time: 2 minutes

Image credit: Mikhail Nilov via Pexels

Free Cash Flow (FCF) is a critical financial metric that represents the cash generated by a business’s operations after accounting for capital expenditures necessary to maintain or expand its productive capacity. It is a measure of the cash available for distribution to investors (such as shareholders and debt holders) or for reinvestment in the company. FCF is often used to assess a company’s financial health, its ability to meet its financial obligations, and its capacity for growth and investment.

The formula for calculating Free Cash Flow is relatively straightforward and can be expressed in different ways, but the most common method involves the following components:

Free Cash Flow (FCF) = Operating Cash Flow (OCF) – Capital Expenditures (CapEx)

Operating Cash Flow (OCF)

This represents the cash generated or used by the company’s core operating activities. It’s often found on the cash flow statement and can be calculated using various methods, including the direct method, indirect method, or from the net income.

Capital Expenditures (CapEx)

This includes the expenditures made to purchase, upgrade, or maintain long-term assets like buildings, machinery, and equipment. CapEx is typically found in the investing activities section of the cash flow statement.

Calculating Free Cash Flow

Determine the Operating Cash Flow, which measures cash generated from the company’s core business activities.
Subtract Capital Expenditures (CapEx), which represents cash spent on investments in assets.

The result is the Free Cash Flow, which indicates the surplus cash available to the company for various purposes, such as debt repayment, dividends, share buybacks, acquisitions, or reinvestment in the business.

It’s important to note that while this is the basic formula, there may be variations and adjustments depending on how a company’s financial statements are prepared or the specific goals of the analysis. Additionally, some analysts prefer to use levered free cash flow (FCFF) when considering cash flows available to both equity and debt holders, which involves further adjustments for interest expenses and other financial obligations.

Free Cash Flow analysis is valuable for assessing a company’s financial health, its ability to pay dividends or reduce debt, and its capacity for growth through investments. It is also a common metric used in valuation models and investment analysis.

Jun Yan

Jun Yan

Jun Yan is the co-founder and director at Ravit Insights. Prior to this, he was a commercial banker at NAB.

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