How to Calculate Free Cash Flow: Formula, Analysis & Example

Instructor: Anne Marie Orr

Anne Marie is an experienced educator of 15+ years, has a Master's Degree in Education and was designated a Master Teacher for State of Ohio.

Free cash flow is an important financial measurement for any business. It is a signal that the company can pay down debt, buy back stock, pay out dividends or allow for company expansion. In this lesson, you will learn the basics of free cash flow.

Free Cash Flow - An Overview

Do you enjoy having a little money left over after paying your bills? You could replace that worn out sofa, take a trip, or even stow it away for a rainy day. Guess what? Businesses are no different from us in this regard, but what we tend to call 'mad money' they refer to as free cash flow.

What Is Free Cash Flow?

Free cash flow is defined as the measure of the amount of cash a business has generated after capital expenditures have been accounted for. (Capital expenditures are things like the purchase of a building, equipment upgrades, technology and vehicles, etc.) This free cash flow can then be used for various purposes, such as reduction of debt, paying dividends, or even expansion. As we work through this lesson, we will use a sample business, ABC Company, to demonstrate free cash flow.

Free cash flow

How Free Cash Flow Is Calculated

In order to calculate free cash flow certain data is needed, which can often be found on a cash flow statement. A cash flow statement is a critical financial statement that reports the amount of cash generated and used throughout a specified interval that is selected by the company.

In order to demonstrate this principle, consider the following:

The formula for free cash flow is Free Cash Flow = Operating Cash Flow - Capital Expenditures.

Let's say that ABC Company reports a cash flow statement of $5 million from operations and $3 million of capital expenditure for Quarter 1. This tells us that ABC Company has a free cash flow value of $2 million. How did we find that figure? Looking at the formula again, we see that $2 million = $5 million - $3 million.

Why This Matters

ABC Company shows that it has cash to expand in the form of free flow, meaning they have the potential to reduce debt, develop products and buy back stock, among other beneficial activities. A rising free cash flow often indicates that a company is not only surviving, but thriving in the current economic environment. Likewise, investors often seek out companies with free cash values that are high but have share prices that are undervalued, with the projection that share prices will increase in the near future.

Free cash flow is an indication of financial health of a company.

Earnings and Free Cash Flow: What's the Difference?

When assessing the financial well-being of a company, free cash flow can be very useful because it strips back accounting assumptions that are built into earnings. Earnings are the profit amounts produced by a company during a specified period, such as a month, quarter or year. This means that just because a company has earnings that are high and continuing to grow doesn't mean you necessarily know when the money was actually generated. It could be the given year, but perhaps not. Earning do not represent real cash, but free cash flow does.

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