What is free cash flow and why does it matter?

Revolut Contributor

 · August 05, 2020  · 08/05/2020

Free cash flow (FCF) is a metric which reveals the liquidity of a business (i.e. its access to cash) as well as its operating efficiency. In straightforward terms, free cash flow is the amount of cash that the business creates from its day-to-day operating activities once you remove capital expenditure from the picture.

What does free cash flow mean?

To understand free cash flow, you must first grasp the premise of operating cash flow, which we cover here. Put simply; the operating cash flow is one of three sections on a cash flow statement:

  • Operating cash flow (i.e. activities related to operations e.g. sales revenue or supplier costs)
  • Investing cash flow (i.e. activities related to investment e.g. purchase or sale of machinery)
  • Financing cash flow (i.e. activities related to providers of capital e.g. long-term loans)

The most insightful section is the operating cash flow (OCF) because it reveals whether the business generates enough cash to cover its everyday activities without seeking short-term credit. The single most noticeable distortion to this figure is the effect of payments for fixed assets, such as machinery.

When you calculate cash flow, the first step is to strip-out the amount shown in the accounts for the depreciation in the value of fixed assets, as this is a ‘non-cash’ transaction. The exception is if the business pays for these assets in the same period as the cash flow statement. In which case, this chunky sum gets recorded as capital expenditure (i.e. CAPEX) within the investing cash flow section.

The reason why free cash flow is important is because it removes the costs of CAPEX payments from the operating cash flow. This FCF figure is said to provide a realistic metric for the cash flow in the business, as it represents the cash that is available to repay creditors or pay dividends to its investors.

What is the formula for free cash flow?

Based on the definition of free cash flow, it is clear that the free cash flow formula is as shown below:

Free cash flow = Operating cash flow – Capital expenditure

When you think about how to calculate free cash flow, the most sensible place to begin is to identify the operating cash flow and capital expenditure figures on the cash flow statement of the business. Once you do this, the free cash flow calculation is basic arithmetic.

What is free cash flow to equity (FCFE)?

This metric takes the concept of free cash flow one step further because it takes into account the interest a business paid on its debts, and also the value of net debt issued or repaid. The combined effect of these tweaks means that the FCFE reveals the cash flow available to the equity investors.

Free cash flow to equity is often called levered cash flow. This idea should never be confused with unlevered free cash flow – also known as free cash flow to the firm (FCFF) – which is a similar cash flow metric that investors typically use to calculate the enterprise value of a business.

What is the difference between cash flow and free cash flow?

The total cash flow shows the net movement of cash for a business in a reporting period. By contrast, the free cash flow figure has a specific meaning, as outlined above. The FCF is a great way to notice lumpy payments for fixed assets or to identify if cash flow is declining due to unsold inventory. This metric enables you to spot these issues on a cash flow statement long before they appear in the net profits.

As you will have noticed, cash flow metrics have many different flavours, depending on what exactly is measured. While free cash flow does have a specific definition, even experts use these terms loosely. It’s always wise to check in meetings that everyone is referring to the same idea to avoid confusion.

Read next:

Sign up in minutes