Free Cash Flow

Your salary is not the money you can spend. Rent comes out, the boiler dies and has to be replaced, and if you want to earn more next year you might pay for a course. What is left after all of that — after the bills and after the spending that keeps your earning power intact — is the money genuinely free to save, invest or hand to somebody else.

Companies work the same way. Reported profit is a performance measure, not a pot of spendable money. Some of the cash a business collects has to go straight back in: machines wear out, delivery vans need replacing, servers need upgrading. Free cash flow (FCF) is what survives that. It is the cash a business could hand to the people who funded it without shrinking itself in the process.

The simple version

The quickest route starts from the cash flow statement:

$$\text{FCF} = \text{cash from operations} - \text{capital expenditure}.$$

In words: take the cash the business actually generated from trading, then subtract what it had to spend on long-lived assets. Both figures sit on the face of any filing, so this version takes about ten seconds and is right often enough to be useful.

Two flavours, and why the difference matters

Once you use FCF to value something, you have to be careful about whose cash you are counting.

Free cash flow to equity (FCFE) is the cash left for shareholders, after lenders have been paid. Interest has already been deducted, and net borrowing is added back:

$$\text{FCFE} = \text{CFO} - \text{capex} + \text{net borrowing}.$$

Free cash flow to the firm (FCFF), also called unlevered FCF, is the cash available to everybody who funded the business — lenders and shareholders together — before any financing decisions:

$$\text{FCFF} = \text{EBIT}\,(1 - t) + \text{D\&A} - \Delta \text{NWC} - \text{capex}.$$

Reading that left to right: start with operating profit, tax it as if the company had no debt at all, add back depreciation and amortisation because no cash left the building, subtract cash swallowed by growth in working capital, and subtract capital spending. The result belongs to the whole capital structure, which is why it is the number a DCF normally discounts.

Worked example one: the quick route

A company reports operating cash flow of 120 and capital expenditure of 60, both in millions. Then

$$\text{FCF} = 120 - 60 = 60.$$

If it also drew 20 of new debt and repaid nothing, FCFE is $120 - 60 + 20 = 80$. Note what just happened: borrowing raised the cash available to shareholders without the business earning a penny more. That is why comparing FCFE across companies with different debt loads is misleading, and why analysts reach for FCFF instead.

Worked example two: building FCFF from the top

Now the unlevered version, same firm. EBIT is 115, the tax rate is 25%, depreciation and amortisation is 45, working capital grew by 25, and capex is 60.

$$\text{FCFF} = 115 \times 0.75 + 45 - 25 - 60 = 86.25 + 45 - 85 = 46.25.$$

So the business generates roughly $46m a year that belongs to all its funders, before any decision about debt. If it has a market value of $700m across debt and equity, the FCF yield is $46.25 / 700 = 6.6\%$ — a rough sense of what you earn from the cash the business throws off, ignoring growth.

Compare that with EBITDA of 160. The gap between 160 and 46 is not noise; it is taxes, growth and the cost of physically keeping the company alive. This is the standing objection to valuing a capital-hungry business on EBITDA multiples.

Where it actually gets used

Three places, mostly. It is the input a DCF discounts, so every assumption you make about capex ends up inside a share price. It is the numerator of FCF yield, the closest thing equities have to a bond's coupon yield, which is how value investors screen. And the ratio of FCF to net income — cash conversion — is a blunt but effective earnings-quality check: a firm reporting rising profit while converting less and less of it into cash is telling you something the income statement is not.

Common pitfalls

• Treating high FCF as unambiguously good. A firm with no investment opportunities produces beautiful free cash flow right up until its revenue stops growing.
• Adding back share-based compensation and stopping there. No cash left, true, but shares were issued, and buying them back later costs real money.
• Comparing FCFE across capital structures. Leverage moves FCFE around without changing the underlying business. Use FCFF for like-for-like comparison.
• Trusting a company's own "adjusted free cash flow." There is no accounting standard for FCF. Always rebuild it from CFO and capex yourself.