Understanding the free cash flow formula

Free cash flow is the cash that a company generates after considering all the cash outflows. A cash outflow might be done to stay in business or to maintain the capital assets which the company has acquired.

What is the difference between free cash and net income? Net income involves the deduction of non-cash expenses like depreciation, amortization, etc. while in free cash flow all non-cash expenses like the one mentioned above are excluded.

Calculating free cash flow

Free cash flow formula can be understood as below:

Free cash flow = Operating cash flow – Capital expenditure

You can also break down the above formula even further resulting in:

Free cash flow = Net Income + Non Cash expenses - Increase in Working Capital - Capital Expenditures

Net Income: Can be directly taken from income statement

Non-cash expenses: Includes all expenses like depreciation, amortization, stock-based compensation, gains/losses on investments, etc.

Increase in working capital: (Previous year’s account receivables - this year’s account receivables) + (Previous year’s inventory - this year’s inventory) - (Previous year’s account payable - this year’s account payable)

How to Interpret Free cash flow?

Free cash flow is an interesting metric to measure. Free cash flow formula considers the working capital while being calculated, it gives an insight into how the company is functioning and other fundamentals.

For example, if the account payables have increased, it can clearly imply that the company is not paying its suppliers on time and is increasing its liabilities. If the account receivables have increased, that could be inferred as that the company is not able to collect payment from its customers on time and thus have a lot of stuck up capital.

Similarly, if the inventory has increased, that means the company is not able to dispose of raw material, work in progress goods, and finished goods on a regular basis.

When we include working capital in the calculation, we get to see a lot of insights that are otherwise not visible in the income statement.

Free cash flow is also a great metric for future lenders or shareholders of the company. In free cash flow formula , all possible outward cash flows are already taken, so knowing the credit-worthiness of a company is easier. You just need to deduct the current outstanding liability from the Free cash flow to know how much more can be lent to the company.

Similarly, shareholders can deduct the interest payments from free cash flow and get a decent idea about the stability of dividend payments.

Limitations of free cash flow formula

By and large, free cash flow is a good measure to judge the strength of a company’s operating capability. However, one of the major limitations of free cash flow formula is its inability to handle uneven distribution. It might happen that the free cash flow (in the year heavy capital expenditure is done) might be lower as compared to any other year.

So, in the Free cash formula, we cannot consider this and hence might give irregular results. Any analyst might need to do some detailed analysis to understand why the free cash flow is uneven in certain years.

We hope this basic understanding of our Free cash flow formula is useful for you and you have understood its benefits, interpretation and limitations.

Read next:

• What is cash flow analysis and why does it matter?
• How to calculate cash flow with the indirect method
• Free Cashflow Forecast Template

About the Author

Ashutosh Garg works as a Product Manager at Refrens.com - A platform for freelancers to manage their finances and generate more leads. You can follow Refrens.com on Twitter, LinkedIn.