Free Cash Flow: Meaning and How to Calculate

The Free Cash Flow (FCF) or free cash flow, is one of the different forms of measurement of cash flows or cash, used in the valuation of investment projects of companies.

It is a crucial indicator of the financial health of a company to determine whether or not to invest. Or if you're a business owner, the index is essential to show how your business is doing to attract partners and investors.

As we will analyse below, the Free Cash Flow represents the flow of funds generated by the company, regardless of how it is financed. Likewise, to complement the content, we will show how to calculate the FCF through a simple mathematical formula.

unlevered free cash flow

What does cash flow mean?

Cash flow is a financial report showing both income and net expenses of a corporation.

This simple calculation, where income and expenses are subtracted respectively, gives a complete view of the company's financial status. In turn, it is an expression of corporate liquidity and how capable it is of meeting its debts and financial expenses. This being a very important aspect when choosing companies to invest in.

Today, there are different ways of measuring cash flow, including cash flow to the shareholder (ECF), capital cash flow (CCF), operating cash flow or free cash flow. We will focus on the latter.

What is a company's free cash flow?

Free cash flow, or FCF, is the amount of fund left after a company pays it operating expenses such as mortgage/rent, staff payroll, inventory cost, capital expenditures, etc.

It is also the financial report or indicator that basically measures cash flows. This flow comes from the money generated by the business or the company's productive activities, deducting production expenses.

The final result of the Free Cash Flow allows identifying how much money is available to pay investors and creditors. On the other hand, it gives the possibility to segregate the capital to know in what it can be reinvested.

What does the Free Cash Flow indicate?

Broadly speaking, FCF is an indicator of the company's financial status. It shows the amount of net cash flow available after deducting cash outflow and operating expenses, including investments and production inputs.

With this, directors will be able to make efficient decisions about how to reinvest the excess money, product of the gross business exploitation.

At the same time, it is an indicator that reveals whether the investments necessary to maintain the business or the interests and dividends paid are too high in relation to the cash flow generated.

For this reason, it is commonly used by analysts and investors to determine a company's real ability to generate profits in opposition to Net Accounting Profit.

Types of Free Cash Flow

Diving deeper into the concept of Free Cash Flow, it is pertinent to emphasize the ways in which it is divided, that is, its typology. The types include:

Levered Free Cash Flow

It is the calculation derived from the original FCF. It results expresses the net or real money that the company has after deducting operating expenses, including debts and some tax issues.

On the other hand, it is known as Shareholders' Free Cash Flow, since the amount of money resulting will be distributed among the main investors of the project in question.

Unlevered Free Cash Flow

When a company is dedicated to the exploitation of some product, service or good, it receives a remuneration or gain in this regard. The money it can produce will be proportional to its operational activity and, with the help of the Unlevered Free Cash Flow, it is established how much it will have to assume debts.

In simple terms, the unlevered free cash flow is the company's cash flow before taking interest payment or other financial obligations.

How to calculate Free Cash Flow

You can calculate the cash flow of an institution using three major ways. The method include:

  • Use of operating cash flow
  • Use of sales revenue
  • Use of net operating profits

Regardless of the method you use to determine the free cash flow amount, the value remains the same.

1. Use of Operating Cash flow

free cash flow calculation

This is the simplest and most common method of calculating cash flow and it involves the use of cash flow from operation and capital expenditures. These values are on the financial statement of the company. The operating cash flow can also be referred to as ‘cash flow from operation' or ‘net cash from operating activities.'

The formula to calculate the Free Cash Flow is:

Free Cash Flow = Operating Cash Flow – Capital Expenditures

Where:

  • Operating Cash Flow: It represents the amount of cash that a company generates through its commercial operations. It is calculated by subtracting total expenses from total/net income of the company. The formula is:

Operating Cash Flow = Total Income – Total Expenses

  • Capital expenditures: It represents the expenditure that a company makes in capital investments, such as the purchase of machinery and equipment, construction of facilities, among others. Capital expenditures are subtracted from the operating cash flow to determine the amount of cash available after the company has made its capital investments.

2. Use of Sales Revenue

The use of sales revenue involves the subtraction of the cost associated with generating a revenue from the total revenue the company generated within a specific period.

It generally uses the income statement and balance sheet as information source. Locate the total revenue on the income statement and then subtract all operating cost, taxes, and other required operating capital.

The formula is given below:

Free Cash Flow = Sales Revenue – (Operation cost + Taxes) – Required Operating Capital

Where:

  • Operating capital: is the capital value required for companies/organizations to continue their daily activities. It is given as the difference between the total net operating capital of two different activity years. It is represented below as:

Required Investment in Operating Capital = Year One Total Net Operating Capital – Year two Total Net Operating Capital

Where:

  • Total Net Operating Capital: is the sum of the net operating working capital and operating long-term assets including the net plant, property, equipment. It's given as:

Total Net Operating Capital = Net Operating Working Capital + Operating Long-term Assets (Net Plant, Property, and Equipments)

Also,

  • Net Operating Working Capital: is the difference between the company' current assets and current liabilities. It is given as:

Net Operating Working Capital = Operating Current Assets + Operating Current Liabilities

In addition, a company current assets and liabilities are calculated by:

Operating Current Assets = Cash + Account Receivables + Inventory

Operating Current Liabilities = Account Payables + Accruals

3. Use of Operating Profits

To calculates free cash flow using net operating profits after taxes is simply subtracting the net investment in operating capital. It is given as:

Free Cash Flow = Net Operating Profit After Taxes – Net Investment in Operating Capital

Generally, you should get the same Free Cash Flow value with any of these methods. It is important to keep in mind that there are different variations of Free Cash Flow that can include other factors, such as the impact of taxes and changes in working capital. However, the basic formula of Free Cash Flow is the one shown above.

Negative Free Cash Flow result

As one might imagine, a negative or declining Free Cash Flow indicates that the company is not generating an efficient net cash flow from its productivity.

In drastic cases, it is synonymous with drastic decisions, such as the sale of part of its investments, shares or increasing debt securities. All this in function of preserving margins and optimal operational levels for its income.

It can also indicate a strategic or tactical imbalance in the company's balance of payments and receipts.

Positive of Free Cash Flow result

On the contrary, a positive result of Free Cash Flow symbolizes a financially sound company. In essence, a high net cash flow is a quality that exudes companies with good profitability and constant growth.

It is also a clear indication that the company can pay its investors and creditors, as well as meet its operating expenses and continue reinvesting.

Ratios that use the Free Cash Flow

To value a company, ratios based on this metric are essential.

  • Remember to compare it with similar companies and with the sector's and company's own historical data.
  • Take into account the type of company and the country in which they are located.
    • For example, Japanese companies are cash generating machines, but then they usually have a questionable allocation of it.

Conclusion

As you can see, Free Cash Flow or free cash flow is one of the main measures for the profitability of a company.

Shareholders and owners will have to take into account and control this flow, since it represents the money that is available to reinvest in the business, that is, to acquire new assets, advance the payment of debts, distribute dividends or save it as reserves.

FAQs about Free Cash Flow

What does Free Cash flow tell you?

Free cash flows tell about the cash a company or company cooperation have left after paying all its operational charges. The amount left shows how large the profit margin is, probable amount to be shared among investors, how good the product/service is, and the chance of making good return if you invest in it shares.

What is the difference between the Free Cash Flow and the Net Cash Flow?

The net cash flow indicates the total amount the company/business obtain from it services including cash for operational activities and investments while free cash flow is the amount left after removing all operational costs, taxes, and capital expenditures.

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