What is Free Cash Flow Formula? (FCF Formula)
When producing the financial metrics of a business, there are many different ways to see and calculate cash flow. Despite the variations, it's vital that business leaders keep a pulse on cash flow as a measure of business health.
This post focuses on the definition of free cash flow and the free cash flow (FCF) formula. After reading, you'll understand what this measurement shows, why businesses need free cash flow, and how you can quickly calculate it using one of several methods.
Here’s What We’ll Cover:
What is Free Cash Flow?
Free cash flow (FCF) is generally defined as the amount of cash after accounting for existing cash outflows. This includes operational costs, investments costs, payroll, and any other expense of remaining in business.
Free cash flow is, in part, what the name implies–free to use at a company's discretion. Since this money is still available after major expenses and investments, it illustrates how strong a business is at generating surplus cash.
Free cash flow (FCF) appears on the cash flow statements of a business. Investment bankers and advisors may be interested in this total if they are helping make business decisions.
Types of Free Cash Flow
There are multiple options for depicting free cash flow on cash flow statements. Two of the most popular definitions are:
- Levered free cash flow – Levered free cash flow refers to the cash a company has after satisfying its recurring financial obligations.
- Unlevered free cash flow – Unlevered free cash flow does not take operating expenses into account. Instead, unlevered free cash flow represents the amount of cash available before those transactions are settled.
For the purpose of this guide, we will focus on free cash flow in the most simplified sense. Free cash flow (FCF) is easiest to calculate, while still showcasing enterprise value.
How is Free Cash Flow Different From Operating Cash Flow?
Free cash flow is the amount of money that is left after subtracting capital expenditures. On the company cash flow statement, free cash flow (FCF) will appear as discretionary cash.
In comparison, operating cash flow is the money that a company generates from its standard operating activities. Operating cash flow (OCF) is used to illustrate whether a business is sustainable for the long haul.
Both measurements shed some light on the business operations of a company. Additionally, the data from each type of cash flow can be used to answer questions from investors, buyers, business analysts, and internal stakeholders.
How to Calculate Free Cash Flow
There are a few representations of the free cash flow formula, ranging from simple to complex. To get started, however, all you need to do is follow the easy formula below.
Free cash flow = Operating cash flow - Capital expenditures (Capex)
That's it! Keep in mind that capital expenditures include any money that the company uses to buy, maintain, or fix assets.
Most of the time, capital expenditures involve physical capital assets like equipment, machinery, land, and building structures.
Free Cash Flow Formula Example
To see how the basic free cash flow formula works in real life, imagine a growing construction business. The company has an operating cash flow of $150,000 and capital expenditures totaling $100,000.
Free cash flow = $150,000 - $100,000
In this straightforward example, the construction company's cash flow statement would show a free cash flow total of $50,000. This money is available to use at the discretion of financial decision-makers.
Variations to the Free Cash Flow Formula
If a business does not provide or publicly list its capital expenditures, there are other methods for calculating free cash flow. Two additional methods involve the use of sales revenue and net operating profits.
Formula with Sales Revenue
The second method for calculating free cash flow focuses on sales revenue that a company generates through its business procedures.
Free cash flow = Sales revenue - Operating costs and taxes - Investments in operating capital
Formula with Net Operating Profits
The third method for calculating free cash flow is even more detailed. This method uses operating income instead of sales revenue to reach the final cash amount.
Free cash flow = Net operating profit after taxes - Net investment in operating capital
Why Is There More than One Free Cash Flow Formula?
Every company operates in its own unique way. While some disclose operating costs, other businesses publish different financial information.
As a result of the discrepancies, financial analysts and advisors need options for calculating free cash flow while still producing consistent results.
Who Uses the Free Cash Flow Formula?
There are two main groups of individuals who may choose to leverage the free cash flow formula. These are:
- Financial leaders within the company, including business partners
- Potential investors or buyers
Business leaders may look at free cash flow to make future decisions on capital expenditures and assets. Since free cash flow indicates the amount of money available for optional spending, it's a good way to measure what risks and investments a company can make in order to grow and expand into its target market.
On the other hand, investors may view this metric through the lens of cash potential and financial well-being. The data can show whether there is room for acquisition, risk, and the expansion of business operations.
Why is the Free Cash Flow Formula Important?
Free cash flow is important because it enables a business to grow. Without cash assets that a company can use to invest, it's challenging to scale. Cash flows in this category are often used for product development, asset procurement, and acquisitions.
Knowing how to use the free cash flow formula is one of the easiest ways to highlight enterprise potential.
This information is also not as easy to manipulate as other cash metrics, such as net income.
Pros of Using Free Cash Flow
Investors and other stakeholders may favor the use of free cash flow for the following reasons.
- It can contribute to increased stakeholder value.
- Free cash flow (FCF) is the best way to view discretionary (optional) spending potential.
- It is just one metric that companies can lean on to paint a more complete picture of available assets, debts, and growth.
- If the free cash flow formula shows a surge in money, the odds are strong that a company's proposed value and earning potential are high.
Cons of Using Free Cash Flow
Despite the benefits of knowing how to calculate free cash flow, there are a few downsides that business leaders should be aware of.
- General free cash flow (FCF) is not as detailed as producing calculations for levered and unlevered free cash flow, which investors may be interested in.
- Companies in different industries may have varying standards for what is considered strong free cash flow. As a result, FCF should always be viewed through the lens of a specific industry.
- The calculation for free cash flow depends on capital expenditure. Since this amount varies quarterly and annually, regular calculations for FCF are required to reach the most accurate picture of a company's cash flow health.
Is Negative Free Cash Flow a Bad Sign?
Although it's always preferable to see positive numbers on a cash flow statement, negative free cash flow calculations may simply mean that a business is making good investments in the future.
As long as operating expenses are reasonable, negative free cash flow does not imply a bad business forecast. In many instances, investors show favor to business models that include substantial investments.
More Cash Flow Accounting Resources
- What is a Cash Flow Statement? Definition and Importance
- How to Make a Financial Statement for Small Business
- 10 Cash Flow Management Tips to Grow Your Business