Free Cash Flow

Free cash flow (FCF) is the cash a company produces from its normal operations after paying for the investment in long-term assets needed to keep the business running and growing. It represents the money available to pay dividends, buy back shares, repay debt, make acquisitions or simply build up cash. Because it is based on actual cash rather than accounting profit, many investors regard it as a clearer measure of a company's financial strength than earnings alone.

Free cash flow is not defined by US GAAP or IFRS, so it does not appear as a line in the audited statement of cash flows. Instead, companies and analysts calculate it from figures in that statement. When a US public company reports free cash flow in its earnings releases, the SEC treats it as a non-GAAP measure, which means the company must reconcile it to the most comparable GAAP figure, usually cash from operating activities, and must not present it more prominently.

The most common definition is:

Here $\text{Cash from operating activities}$ is the net cash generated by the business's day-to-day operations, taken from the operating section of the cash flow statement, and $\text{Capital expenditures}$ are payments for property, plant, equipment and capitalized software, taken from the investing section. Operating cash flow already reflects interest and taxes paid under US GAAP, as well as changes in working capital.

A software company reports net income of $40 million. Its cash flow statement adds back $15 million of depreciation and amortization and $10 million of stock-based compensation, and subtracts $5 million for an increase in receivables, giving cash from operating activities of $60 million. During the year it spends $18 million on servers and office fit-outs, recorded as capital expenditure.

• Free cash flow is $60 million minus $18 million, which equals $42 million.
• If the company has 100 million shares, free cash flow per share is $0.42.
• If its market value is $1.05 billion, its free cash flow yield is $42 million divided by $1.05 billion, or 4 percent.

The company could use the $42 million to pay a dividend, retire debt or fund growth without raising new money.

Analysts use two main versions when valuing a business with a discounted cash flow model:

• Free cash flow to the firm (FCFF), or unlevered free cash flow, is the cash available to all providers of capital, lenders and shareholders alike. It is usually calculated from operating profit after tax, plus non-cash charges, minus capital expenditure and minus the increase in working capital, and it is discounted at the weighted average cost of capital.
• Free cash flow to equity (FCFE), or levered free cash flow, is what remains for shareholders after interest, debt repayments and new borrowing, and is discounted at the cost of equity.

Some companies also report adjusted measures, for example excluding acquisition-related payments or including lease principal repayments. Because definitions vary, readers should check exactly how a company defines the figure.

Persistent free cash flow that is close to or above net income suggests high-quality earnings that are backed by cash. A company that reports rising profits but negative free cash flow may be building up receivables or inventory, or may need heavy reinvestment just to stand still. However, negative free cash flow is not always bad: a young, fast-growing company may be investing heavily in assets that will produce cash later. Free cash flow can also be flattered in the short term by cutting necessary maintenance spending, delaying payments to suppliers or selling receivables. Comparing it over several years, and against EBITDA and operating income, gives a more reliable picture of a business's underlying cash flow and long-term valuation.