Free Cash Flow, often abbreviate FCF, is an efficiency and liquidity ratio that calculates the how much more cash a company generates than it uses to run and expand the business by subtracting the capital expenditures from the operating cash flow. In other words, this is the excess money a business produces after it pays all of its operating expenses and CAPEX. This is an important concept because it shows how efficient the business is at generating cash and if it can pay its investors a return after it funds its operations and expansions.
What is Free Cash Flow?
Investors and creditors use this ratio to analyze a business in a number of different ways. Investors like this measurement because it tells the truth about how a business is actually doing. Other financial ratios can be adjusted or changed by management’s treatment of accounting principles. That’s not really possible with this calculation. It’s difficult to fake the cash flow coming in and leaving a company. Thus, investors look at this ratio to gauge how well the business is doing and more importantly will it be able to provide a return on their investment.
Creditors, on the other hand, also use this measurement to analyze the cash flows of the company and evaluate its ability to meet its debt obligations.
Now that we know why this ratio is important, let’s answer the question what is FCF?
The free cash flow formula is calculated by subtracting capital expenditures from operating cash flow. The OCF portion of the equation can be broken down and be calculated separately by subtracting the any taxes due and change in net working capital from EBITDA.
As you can see, the free cash flow equation is pretty simple. It basically just measures how much extra cash the business will have after it pays for all of its operations and fixed asset purchases.
Keep in mind, that we are measuring cash flow. We aren’t measuring the cumulative cash asset account. This measurement compares the money coming in the door to the money being paid out for operations and expenditures. If there are excess funds, the company can give some to their investors. If there is a deficit, the company will have to dip into savings or take out a loan to fund its activities.
Let’s take a look at an example.
Tim’s Tool Shop is a small home improvement store that sells tools and other household goods. Tim wants to expand into new territories, but he can’t do it on his own. Thus, he wants to bring on new investors. The new investors want to analyze the store’s free cash flows to see if it would be worth their time.
Tim’s income statement shows that he had a net profit of $100,000 after taxes last year. In order to calculate the operating cash flow, we need to add back any non-cash expenses that reduced his net income like depreciation and amortization. We also have to adjust the profit for the change in working capital. Tim’s financial statements listed the following numbers:
- Depreciation: $10,000
- Amortization: $5,000
- Current assets: $100,000
- Current liabilities: $80,000
- Fixed asset purchases: $50,000
Thus, Tim would calculate his OCF like this $100,000 – ($100,000 – $80,000) + $10,000 + $5,000 = $95,000. Here’s how to calculate free cash flow for Tim’s business using the FCF formula:
As you can see, Tim’s free cash flow is greater than his capital expenditures. This excess free cash flow can be used to give investors a return or invest back into the business. If Tim’s CFC was less than his capital expenditures, he would have negative free cash flow and would not have enough money coming in to pay for his operations and expansions.
What is Free Cash Flow Used For?
Since the free cash flow equation is both an efficiency and liquidity ratio, it gives investors a great deal of information about the company. Obviously, in most cases a larger FCF is always better than a lesser number because it indicates that the company is doing well and its operations are able to fund all of its activities while throwing off excess cash for its investors.
Going back to our example, Tim’s business generated $45,000 in excess of what it needed to run the operations and fund the new capital investments. This $45,000 could be put back into the business to purchase more inventory, or it could be used to issue Tim and his new investors a dividend at the end of the year. This is exactly what Tim’s new investors want to see. They want to see that the business operations are healthy and efficient enough to generate excess funds.
It’s important to note that excess cash does not always mean the company is doing well or what it should be doing to grow in the future. For example, a company might have positive FCF because it’s not spending any money on new equipment. Eventually, the equipment will break down and the business might have to cease operations until the equipment is replaced. For instance, Tim’s delivery truck might need to be replaced. If the truck is inoperable, he might lose orders.
Conversely, negative free cash flow might simply mean that the business is investing heavily in new equipment and other capital assets causing the excess cash to disappear. Like with all financial ratios, FCF is a peak into how a company is operated and the strategies that management is taking. You have to measure and analyze the numbers to understand why the ratios are the way they are and whether or not a business is healthy.