• Free cash flow (FCF) measures a company’s financial health by showing how much cash is available after expenses and capital expenditures.
  • FCF can show the company’s ability to generate cash, reinvest in the business, or return value to shareholders.
  • Free cash flow doesn’t account for non-cash expenses and might be less effective for companies with high capital needs.

Free cash flow is a powerful metric business owners and investors can use to gauge a company’s financial health. Unlike revenue or net profit, FCF shows the company’s cash on hand after covering essential expenses and capital investments.

Understanding and calculating free cash flow may help business stakeholders make smarter investment decisions, assess the growth potential, and get a realistic view of a company’s ability to generate cash. This guide to free cash flow will explore what FCF is, how it’s calculated, and why it plays a critical role in financial analysis.

Understanding Free Cash Flow

Free cash flow is a type of cash flow that measures the amount of money a business has after paying operating and capital expenses. Knowing what free cash flow is and how it works often lets you see a company’s:

  • True liquidity
  • Capacity for growth
  • Potential returns for investors

What Is Meant by Free Cash Flow? Definition and Significance

The definition of free cash flow is the amount of cash on hand a business has after covering operating expenses and capital expenditures. It focuses on the cash left over that a company can use freely without affecting its essential operations.

FCF may be a good indicator of a business's overall financial health.

For example, businesses with leftover cash may be less likely to face other cash flow problems. Likewise, a high rate of free cash flow could be a sign that a business is generating enough cash to rely on internal funding rather than external financing.

Importance in Financial Analysis

Many businesses use free cash flow as a critical part of the financial analysis of a business. Unlike profit or revenue figures, FCF reflects the actual cash a business generates after necessary expenses are paid.

Cash availability is often a clear sign of operational health in a business, showing that the business may be able to:

  • Reinvest for growth
  • Manage debt
  • Weather economic downturns without relying on outside funding

How To Calculate Free Cash Flow

Calculating free cash flow is possible so long as you have access to certain financial data from a company. To calculate free cash flow, you’ll need to know a company’s:

  • Operating cash flow: This is the amount of cash generated by a company’s core business activities over a certain period.[1]
  • Capital expenditures: Funds spent on significant business investments such as purchasing an office building or upgrading software systems.[2]

Free Cash Flow Formula

Knowing how to calculate free cash flow may help you analyze a company's ability to cover costs with money left over. This may be helpful for both business owners analyzing their own business cash reserves and investors looking to potentially invest in a business.

The free cash flow equation is:

Free cash flow = operating cash flow – capital expenditures

Steps to Calculate FCF

You’ll generally follow three steps to calculate FCF for a business:

1. Determine Operating Cash Flow (OCF)

Start with a company’s cash flow statement to find the operating cash flow, which is often listed near the top of the statement. This figure represents cash the company made from the activities needed to produce and sell a product or service, like sales or marketing.[3]

2. Identify Capital Expenditures (CapEx)

Next, you’ll need to find out how much a business spends on capital expenditures. The amount of capital expenditures is often listed in the investing activities of a cash flow statement.[3]

3. Calculate FCF Using the Free Cash Flow Equation

Subtract your CapEx figure from your OCF amount to get the FCF of a business.

Real-World Example of the Free Cash Flow Equation

Let’s say a business has the following figures on their cash flow statement:

  • Operating cash flow: $500,000
  • Total capital expenditures: $200,000

To calculate this business’s free cash flow, simply subtract the capital expenditures from the operating cash flow:

$500,000 - $200,000 = $300,000 Free cash flow

In this example, the business has $300,000 of free cash on hand to reinvest in the business, pay investor dividends, or reduce additional debt.

Interpreting Free Cash Flow

Knowing how to calculate free cash flow is only the first step in using it to analyze the financial health of a business. You also generally need to know how to interpret your FCF amount.

What FCF Indicates About a Company’s Financial Health

Free cash flow is a good way to analyze a company’s financial health. The higher the free cash flow, the more funds a company has to reinvest in the business or investors. Positive free cash flow may indicate that a business can:

  • Consistently meet its financial obligations
  • Generate enough funding to reinvest
  • Operate with efficiency by controlling costs

Difference Between FCF and Net Cash Flow

While both free cash flow and net cash flow are important for evaluating a business’s cash position, they serve different purposes. Net cash flow represents the total cash inflows minus total cash outflows over a period.

This broad look at a company’s cash flow helps investors and stakeholders understand the overall cash movement of the business. However, net cash flow may not fully capture the amount of cash generated from core business operations.

Free cash flow has a narrower view and is particularly valuable for assessing operational performance and financial flexibility.

For example, a company might have positive net cash flow due to financing activities such as issuing debt or equity. However, this same company could have a low FCF if the operating cash flow isn’t enough to cover capital investments.

Benefits and Advantages of Free Cash Flow

Analyzing free cash flow provides business stakeholders with several benefits, including providing insights into the financial health of a business and helping to convert operating profits into usable cash.

Insights for Investors and Stakeholders

A free cash flow evaluation is one of the most helpful evaluations for business investors and major stakeholders. It offers valuable insights regarding the company’s financial stability and growth potential.

For investors, a high free cash flow is a good sign that their investment might pay off. Consistently high FCF generally results in higher dividends. Additionally, potential investors might use FCF as a guide for investment decisions.

Converting Operating Profits Into Cash

Free cash flow helps a business manage the process of converting operating profits into cash. A company may report strong profits, but that doesn’t guarantee it’s generating equivalent cash flow. Many factors could affect how much cash a business is generating from operations, such as:

  • Changes in working capital
  • Inventory management
  • Accounts receivable and payable delays
  • Seasonal fluctuations

These factors may not directly affect sales numbers but could affect the amount of cash a business has on hand. For instance, a company may hit record sales numbers and report high profits. However, it may run into issues collecting payments from customers, delaying when the cash will be available.

Using free cash flow with profit data might give business stakeholders a more complete picture of when and how the company turns sales and revenue into usable funds.

Limitations of Free Cash Flow

Free cash flow is a great tool, but its use is limited. The best way to use it is to combine it with other insights for a more complete picture of a business.

Potential Drawbacks and Challenges

The three main limitations and disadvantages of using a FCF model include:

Volatility and Seasonality

A company’s FCF may be volatile, especially for businesses with seasonal sales. These fluctuations could cause misleading FCF interpretations when using FCF alone.

Impact of Capital Expenditures

Capital expenditures are a major part of FCF, but substantial capital investments may result in lower FCF — at least temporarily. This lower FCF could be misinterpreted as a sign of financial weakness.

Focuses on Short-Term

The FCF model focuses mostly on the short-term performance of a business. Relying too heavily on FCF figures could cause business management to think in the short term as well. In turn, this could lead to underinvestment in key areas like R&D or employee development, which are crucial for long-term business growth.

Comparing FCF with Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA)

Using FCF alone might limit the benefits of the FCF model. However, comparing a company’s FCF with its Earnings Before Interest, Taxes, Depreciation, and Amortization (EBITDA) often provides a distinct look at a company’s financials.

EBITDA focuses on operational profitability, excluding non-cash expenses, and doesn’t account for capital expenditures.

Both metrics are important for different reasons. FCF gives a clear view of cash generation and liquidity, making it vital for planning and decision-making. EBITDA helps evaluate operation performance against competitors, especially in capital-heavy industries.

Practical Applications of Free Cash Flow

You know what FCF is, but how do you use it to run or analyze a business?

FCF is esepcially helpful when making informed investment decisions on the growth of a business. Additionally, knowing where a company's FCF currently stands often helps you improve FCF amounts over time.

How To Utilize FCF for Investment Decisions

You might analyze FCF to determine how much cash is available for growth opportunities, such as expanding operations or launching new products. A strong FCF position could also indicate your business is capable of distributing a portion of profits to shareholders.

Strategies for Improving FCF

What is a good FCF, and how can you improve it?

There’s no exact number that indicates a good FCF. Businesses generally want to increase their FCF over time so they have more funds available to reinvest in the business. Rather than focusing on a specific number, consider using these strategies to help boost FCF:

  • Optimize working capital: Get the most out of your working capital by optimizing and streamlining processes, such as reducing the amount of inventory kept on hand.
  • Control operating expenses: Regularly review your operating expenses to look for changes to cut expenses, such as switching to a lower-cost supplier.
  • Utilize cash flow resources: Using the resources you have available, such as PNC’s Cash Flow Insight® tools, can help you get the most out of business operations.