What Is the Formula for Calculating Free Cash Flow? (2024)

Free cash flow (FCF) is the money that remains after a company pays for everyday operating expenses and capital expenditures. Knowing a company’s free cash flow can give insight into its financial health.

Learn how a company calculates free cash flow and how to interpret that FCF number to choose good investments that will generate a return on your capital.

What Is Free Cash Flow (FCF)?

Free cash flow (FCF)is the cash a companygenerates after taking into consideration cash outflows that support its operations and maintain its capital assets. In other words, free cash flow is the cash left over after a companypays forits operating expenses (OpEx)and capital expenditures (CapEx).

FCF is the money that remains after paying for items such as payroll, rent, and taxes, and a company can use it as it pleases. Knowing how to calculate free cash flow and analyze it will help a company with its cash management. FCF calculation will also provide investors with insight into a company’s financials, helping them make better investment decisions, and can be easily calculated using Excel or other spreadsheet software.

Free cash flowis an important measurement since itshows how efficient a company isat generating cash. Investors use free cash flow to measure whether a company might have enough cash for dividends or share buybacks. In addition, the more free cash flow a company has, the better it is positioned to pay down debt and pursue opportunities that can enhance its business, making it an attractive choice for investors.

How to Calculate Free Cash Flow (FCF)

There are several different methods to calculate free cash flow because all companies don’t have the same financial statements. Regardless of the method used, the final number should be the same given the information that a company provides.

Three ways to calculate free cash flow are by using operating cash flow, using sales revenue, and using net operating profits. You can also use amortization and depreciation to account for the decreasing value of equipment and plants.

Using Operating Cash Flow

Using operating cash flow to calculate free cash flow is the most common method because it is the simplest and uses two numbers that are readily found in financial statements: operating cash flow and capital expenditures. To calculate FCF, locate the itemcash flow from operations(also referred to as operating cash or net cash from operating activities) from the cash flow statement and subtract capital expenditure.

The formula is:

$\begin{aligned}&\text{Free Cash Flow}=\text{Operating Cash Flow}-\text{Capital Expenditures}\end{aligned}$​FreeCashFlow=OperatingCashFlow−CapitalExpenditures​

Using Sales Revenue

Using sales revenue focuses on the revenue that a company generates through its business and then subtracts the costs associated with generating that revenue. This method utilizes the income statement and balance sheet as the source of information. To calculate FCF, locate sales or revenue on the income statement, subtract the sum of taxes and all operating costs (listed as operating expenses), which include items such as cost of goods sold (COGS) and .

Finally, subtract the required investments in operating capital, also known as the net investment in operating capital, which is derived from the balance sheet.

The formula is:

${\small\begin{aligned}&\text{Free Cash Flow}=\text{Sales Revenue}-\text{(Operating Costs}+\text{Taxes})-\text{Required Investments in Operating Capital}\\&\textbf{where:}\\&\text{Required Investments in Operating Capital}=\text{Year One Total Net Operating Capital}-\text{Year Two Total Net}\\&\qquad\text{Operating Capital}\\&\textbf{and where:}\\&\text{Total Net Operating Capital}=\text{Net Operating Working Capital}+\text{Net Plant, Property, and Equipment}\\&\qquad\text{ (Operating Long-Term Assets)}\\&\textbf{and where:}\\&\text{Net Operating Working Capital}=\text{Operating Current Assets}-\text{Operating Current Liabilities}\\&\textbf{and where:}\\&\text{Operating Current Assets}=\text{Cash}+\text{Accounts Receivables}+\text{Inventory Operating Current Liabilities}\\&\qquad=\text{Accounts Payables}+\text{Accruals}\end{aligned}}$​FreeCashFlow=SalesRevenue−(OperatingCosts+Taxes)−RequiredInvestmentsinOperatingCapitalwhere:RequiredInvestmentsinOperatingCapital=YearOneTotalNetOperatingCapital−YearTwoTotalNetOperatingCapitalandwhere:TotalNetOperatingCapital=NetOperatingWorkingCapital+NetPlant,Property,andEquipment(OperatingLong-TermAssets)andwhere:NetOperatingWorkingCapital=OperatingCurrentAssets−OperatingCurrentLiabilitiesandwhere:OperatingCurrentAssets=Cash+AccountsReceivables+InventoryOperatingCurrentLiabilities=AccountsPayables+Accruals​

Using Net Operating Profits

To calculate free cash flow using net operating profits after taxes (NOPATs) is similar to the calculation of using sales revenue, but where operating income is used.

The formula is:

${\small\begin{aligned}&\text{Free Cash Flow}=\text{Net Operating Profit After Taxes}-\text{Net Investment in Operating Capital}\\&\textbf{where:}\\&\text{Net Operating Profit After Taxes}=\text{Operating Income}\times(1-\text{Tax Rate)}\\&\textbf{and where:}\\&\text{Operating Income}=\text{Gross Profits}-\text{Operating Expenses}\end{aligned}}$​FreeCashFlow=NetOperatingProfitAfterTaxes−NetInvestmentinOperatingCapitalwhere:NetOperatingProfitAfterTaxes=OperatingIncome×(1−TaxRate)andwhere:OperatingIncome=GrossProfits−OperatingExpenses​

The calculation for net investment in operating capital is the same as described above.

Using Amortization and Depreciation

To calculate free cash flowanother way,locatethe income statement, balance sheet, and cash flow statement. Start with net income and add back charges for depreciation and amortization. Make an additional adjustment for changes inworking capital, which is done by subtracting current liabilities from current assets. Then subtract capital expenditure (or spending on plants and equipment):

Free Cash Flow = Net income plus depreciation / amortization minus change in working capital minus capital expenditure

It might seem odd to add back depreciation/amortization since it accounts for capital spending. The reasoning behind the adjustment is that free cash flow is meant to measure money being spent right now, not transactions that happened in the past. This makes FCF a useful instrument for identifying growing companies with high upfront costs, which may eat into earnings now but have the potential to pay off later.

Example of Free Cash Flow Calculation

Let’s use department store Macy’s (M) to illustrate how to calculate free cash flow.

Macy’scash flow statementfor the fiscal yearending2022, according tothe company’s10-K statement, indicates:

• Cash flow from operating activities of $1.615 billion
• Capital expenditures of $1.169 billion

To calculate the free cash flow, we subtract capital expenditures from operating cash flow:

• $1.615B - $1.169B = $0.446B, or $446 million

We can see that Macy’shas$446 million in free cashflow, which can be used to pay dividends, expand operations, and deleverage its balance sheet (in other words,reduce debt).

What Free Cash Flow Can Tell You

Growing free cash flows are frequently a prelude to increased earnings. Companies that experience surging FCF—due to revenue growth, efficiency improvements, cost reductions, share buybacks, dividend distributions, or debt elimination—can reward investors tomorrow. That is why many investors cherish FCF as a measure of value. When a firm’s share price is low and free cash flow is on the rise, the odds are good that earnings and share value will be heading up soon.

By contrast, shrinking FCF might signal thatcompanies are unable to sustain earnings growth. An insufficient FCF for earnings growth can force companies to boost debt levels ornot have theliquidityto stay in business.

That being said, a shrinking FCF is not necessarily a bad thing, particularly if increasing capital expenditures are being used to invest in the growth of the company, which could increase revenues and profits in the future.

Advantages and Disadvantages of Free Cash Flow

Advantages

Free cash flow can provide a significant amount of insight into the financial health of a company. Because free cash flow is made up of a variety of components in the financial statement, understanding its composition can provide investors with a lot of useful information.

Of course, the higher the free cash flow, the better. But we have already seen from our Macy’s example that a declining free cash flow is not always bad if the reason is from further investments in the company that poise it to reap larger rewards down the line.

In addition, cash flow from operations takes into consideration increases and decreases in assets and liabilities, allowing for a deeper understanding of free cash flow. So for example, if accounts payable continued to decrease, it would signify that a company is paying its suppliers faster. If accounts receivable were decreasing, it would mean that a company is receiving payments from its customers faster.

Now, if accounts payable were decreasing because suppliers wanted to be paid quicker but accounts receivable were increasing because customers weren’t paying quickly enough, this could result in decreased free cash flow, since money is not coming in quickly enough to meet the money going out, which could result in problems for the company down the line.

The overall benefits of a high free cash flow, however, mean that a company can pay its debts, contribute to growth, share its success with its shareholders through dividends, and have prospects for a successful future.

Disadvantages

One drawback to using the free cash flowmethod is thatcapital expenditures can vary dramatically from year to year and among different industries.That’s why it’s critical to measure FCF over multiple periods and against the backdrop of a company’sindustry.

It’s important to note that an exceedingly high FCF might indicate that a company is not investing in itsbusiness properly, such as updating its plant and equipment. Conversely, negative FCF might not necessarily mean a company is in financial trouble, but rather, investing heavily in expandingits marketshare, which would likely leadto future growth.

Value investors often look for companies with high or improving cash flows but with undervalued share prices. Rising cash flow is often seen as an indicator thatfuture growth is likely.

The Bottom Line

Free cash flow is a metric that investors use to help analyze the financial health of a company. It looks at how much cash is left over after operating expenses and capital expenditures are accounted for. In general, the higher the free cash flow is, the healthier a company is, and in a better position to pay dividends, pay down debt, and contribute to growth.

Free cash flow is one of many financial metrics that investors use to analyze the health of a company. Other metrics that investors can use include return on investment (ROI), the quick ratio, the debt-to-equity (D/E) ratio, and earnings per share (EPS).