Free cash flow (FCF) is a helpful way to measure your company’s financial performance. But what is free cash flow and what exactly does it have to do with your finance ABCs? Find out everything you need to know with our guide to the free cash flow formula, right here.
What is free cash flow?
Free cash flow is a term referring to the capital that your business generates from core business activities after the deduction of capital expenditure (i.e., real estate, machinery, equipment, and other long-term fixed assets). In other words, free cash flow provides an insight into your company’s ability to produce cash and achieve profitability.
Understanding the free cash flow formula
If you’re wondering how to calculate free cash flow, you’ll need to get to grips with the free cash flow formula. Fortunately, it’s a relatively simple two-part equation.
Firstly, you’ll need to find out your operating cash flow (money that your business generates from core business activities, including capital expenditure). You can use the following formula:
Operating Cash Flow = Net Income + Non-Cash Items + Changes in Working Capital
Here’s a little more information about these terms:
Net Income – Refers to the amount of money your business has left over after paying expenses.
Non-Cash Items – Refers to depreciation, amortization, stock-based compensation, losses/gains on investments, and impairment charges.
Changes in Working Capital – Refers to the difference in your net working capital year over year.
Then, using the figure from the previous equation, the free cash flow formula is as follows:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
As you can see, assuming that you have all the relevant information to hand, it’s relatively simple to carry out a free cash flow calculation.
What is a “good” free cash flow?
So, now we know a little more about how to calculate free cash flow, but the question remains: what constitutes a “good” free cash flow? Companies with a high FCF may also experience negative stock trends, whereas a negative free cash flow isn’t necessarily cause for alarm. It may simply indicate that the business is making large investments. To evaluate your business’s free cash flow, you should look at trends over time to get the bigger picture.
Benefits of the free cash flow formula
There are many potential benefits of using the free cash flow formula. Crucially, knowing your business’s free cash flow should give you valuable insight into your financial fundamentals, as it’s a much more difficult figure to manipulate than net income alone. In addition, investors and lenders may use your firm’s free cash flow to evaluate the likelihood that you’ll be able to pay out any expected dividends or interest.
Limitations of free cash flow calculations
Although free cash flow can be a useful financial metric, there are drawbacks that you should keep in mind. Most importantly, different companies will have different accounting policies, which will affect your free cash flow calculation. For example, an asset that one company declares as a capital expenditure may not be declared as a capital expenditure by another business. This can have a dramatic effect on overall free cash flow, so it’s important for investors to scrutinise the figures that they’re working with to ensure that they’re getting the most accurate read on a company’s FCF.
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