What Is Free Cash Flow? Understanding How FCF Works

Free cash flow (FCF) is the amount of money a company has after paying the operating expenses incurred as part of its day-to-day business operations and capital expenditures (the cost of maintaining any long-term expenses or assets). Businesses can use free cash flow for discretionary spending in supporting or growing the business.

Cash flow analysis allows companies to evaluate their financial performance and financial health, including whether their current capital structure allows them to meet their bottom line and fulfill their current liabilities.

On its own, free cash flow helps companies to evaluate the cash they have to spend after considering operating expenses and debts related to maintaining their capital assets. However, there are a few variations on cash flow that companies can use to help further evaluate their viability. Here are five of the most common types of cash flow adjustments that companies use to evaluate their financial health and performance.

1. 1. EBITDA: EBITDA—an acronym that stands for “earnings before interest, taxes, depreciation, and amortization”—is a measure of a company's financial performance. Business owners use EBITDA to monitor their company's cash flow and to analyze the profitability of core operations before taking into account capital expenditures, tax rates, and non-cash expenses. EBITDA is useful for comparing the operating performances of similar businesses in the same industry.
2. 2. Operating cash flow: Operating cash flow, or OCF, helps measure a company's financial health by factoring in its operating income (also known as earnings before interest and taxes, or EBIT) alongside its operating expenses. A positive OCF indicates the company can pay its bills using only its operating revenue. A negative OCF indicates the company must find other sources of money—typically via loans, taking on investors, or liquidating assets—to cover its operating expenses.
3. 3. Free cash flow: Free cash flow, or FCF, represents the cash flows a company receives after capital expenditures (such as the purchase of long-term assets) have been deducted and before interest payments have been accounted for. Free cash flow appears on financial statements to show not only a company's incoming cash flow but also how it manages capital expenditures (sometimes called CapEx).
4. 4. Levered free cash flow: Levered free cash flow, also called free cash flow to equity (FCFE), is a type of free cash flow that accounts for any debts or loan balances the company incurs. Levered free cash flow is often used to determine the cash available for investors after a company’s external financial matters have been settled. FCFE is also used as a financial analysis tool to help determine a company’s equity value.
5. 5. Unlevered free cash flow: Unlevered free cash flow, which also goes by the name of free cash flow to the firm (FCFF), is an estimate of the amount of cash flow from operations a company would have if they had no debt obligations. This number is hypothetical and is used to determine a company’s ability to generate cash. It is another way to evaluate the value of a company.

The easiest way to calculate a company’s free cash flow is to find the company’s cash from operations (CFO) and capital expenditures (CapEx) on the company’s cash flow statement. The simplest free cash flow formula (also called an FCF formula) is as follows: Free cash flow = Cash from operations - Capital expenditures. Alternatively, you can use the following steps to calculate these numbers yourself using figures from a company’s financial statements like the income statement or balance sheet.

1. 1. Calculate cash from operations. Add the company’s net income to their cash from expenses. Then subtract the company’s non-cash net working capital (which could include accounts payable, accounts receivable, or inventory). This number is your cash from operations.
2. 2. Calculate capital expenditures. First, determine the property, plant, and equipment (PP&E) expenses from both the current year and previous year. Subtract the previous year’s PP&E from the current year’s. Add the depreciation and amortization figures. This number is the company’s capital expenditures.
3. 3. Calculate free cash flow. Subtract the capital expenditures you calculated in step two with the cash from operations in step one. This number is your free cash flow.

Cash flow is a general term that refers to the flow of money in and out of a company. You can find a detailed catalog of these inflows and outflows on a company’s cash flow statement (also called statement of cash flows) listed under “cash flow from operating activities.”

Free cash flow is more specific than cash flow because it describes the amount of money that a company has left over after accounting for its operating costs and CapEx. Free cash flow more accurately reflects how much money a company has to spend on its growth and discretionary expenses than general cash flow.

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