Free cash flow, simply explained
Free cash flow is the money a company has left after paying all running costs and investing in its business. It is harder to dress up than profit. It is what a company uses to pay dividends, buy back its own shares or pay down debt.
What is really left over
Picture a baker. At the end of the year he has sold bread and paid for flour, electricity and wages. What is left, the accountants call profit. But this year the baker also had to buy a new oven. That money is gone, even though the oven shows up in the profit figures only bit by bit over many years.
Free cash flow therefore asks a practical question: how much more money is actually in the account at the end of the year – after everything that keeps the business running? That is exactly the money a company can pass on to its owners.
The formula
- Operating cash flow
- money the ongoing business brings in during the year
- Capital expenditure
- spending on machines, buildings, software and the like
Both figures are in the cash flow statement, a mandatory part of every annual report. Operating cash flow is usually called "cash from operating activities", capital expenditure "purchases of property and equipment" or similar.
The worked example
In the article on fair value, the made-up Example Inc. had a free cash flow of €10 per share. This is how it could arise from profit:
| Item | Amount |
|---|---|
| Profit | €11.00 |
| + Depreciation | €4.00 |
| − more money tied up in inventory and unpaid invoices | €1.00 |
| = Operating cash flow | €14.00 |
| − Capital expenditure | €4.00 |
| = Free cash flow | €10.00 |
How to read the table: depreciation is a cost that lowers profit, but no money left the company for it this year – the oven was paid for earlier. That is why it is added back. On the other hand, more money got tied up in inventory and in invoices customers have not paid yet. That is missing from the account and is subtracted. The result is €10 – a little less than profit.
Why profit and cash flow drift apart
Profit follows accounting rules, cash flow follows the money. Both are useful, but they can be far apart:
A growing company often invests much more than it depreciates. Its free cash flow is then below profit, even though it is healthy. A company that hardly invests any more, on the other hand, shows free cash flow above profit – that looks good, but may mean it is living off its substance.
It is a warning sign when profit rises for many years but free cash flow does not keep up. Then the profit is apparently not arriving in the account as money.
Free cash flow per share and yield
Divide free cash flow by the number of shares and you get free cash flow per share. Divide that by the share price and you get the free cash flow yield. If a share of Example Inc. costs €200, that is €10 ÷ €200 = 5%. It tells you how much money the company earns relative to what you pay for it – similar to the P/E ratio, but based on cash instead of profit.
Three common mistakes
See free cash flow over many years.
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Frequently asked questions
Is negative free cash flow bad?
Not necessarily. Young or fast-growing companies often invest more than they take in. What matters is whether the investments bring in money later and whether the company can finance the time until then.
How is it different from EBITDA?
EBITDA is earnings before interest, taxes, depreciation and amortization. It leaves out investment, taxes and interest entirely. Free cash flow subtracts all of that and is therefore closer to the money that is really left over. What EBITDA is still useful for is shown in the article EV/EBITDA.
Where do I find free cash flow?
Many companies state it in their annual report. If not, you calculate it yourself from the cash flow statement: operating cash flow minus capital expenditure. Note that different sources define it slightly differently.
Why does a DCF use free cash flow and not profit?
Because in the end a company can only give its owners money it actually has. A DCF estimates exactly that money for the future and discounts it back to today.
Not investment advice. All content is for informational and educational purposes only. Example Inc. is made up.