In this article, we’ll break down what Free Cash Flow is, why companies calculate it, and, most importantly, how to calculate free cash flow step-by-step using the formula. Don’t worry—we’ll make it beginner-friendly and use real-world examples to make things crystal clear!
When it comes to understanding a company’s financial well-being, you’ve probably heard terms like revenue, profit, or even net income. But have you heard of Free Cash Flow (FCF)? Think of it as the lifeblood of a business—the amount of cash a company generates that it can freely use to grow, pay down debt, or return to shareholders without harming its operations.
What is Free Cash Flow?
Free Cash Flow (FCF) is the cash that a company has left after covering its operating expenses and making necessary investments in its future growth (like buying equipment or opening new stores). It’s what’s left in the bank after the company has done everything it needs to keep the business running and growing.
For example, Imagine you’re running a lemonade stand. You sell lemonade for 100 dollars, but you spend 50 dollars on lemons, sugar, and cups, and another 30 dollars to fix your lemonade stand. The 20 dollars left over is your Free Cash Flow—it’s the money you could save, invest, or even use to buy candy if you wanted to!
Why Do Companies Calculate Free Cash Flow?
Companies calculate Free Cash Flow for a few important reasons:
1. Measure Financial Health: FCF tells managers, investors, and analysts how much cash is truly available after the company has covered all its costs. A positive FCF means the company is generating enough cash to fund its operations and investments, while a negative FCF could signal a cash shortage.
2. Plan for Growth: Companies use FCF to decide how much they can spend on expanding the business, such as opening new stores, building factories, or launching new products.
3. Attract Investors: Investors love companies with strong free cash flow because it shows they have enough cash to pay dividends or reinvest for future growth.
4. Debt Management: Free Cash Flow (FCF) helps companies assess whether they can pay off their loans or reduce debts.
Now, that we know the basics of free cash flow, let’s learn how to calculate free cash flow easily.
How to Calculate Free Cash Flow
To calculate Free Cash Flow, we’ll have to use a formula for Free Cash Flow
Here’s the formula for calculating Free Cash Flow:
Don’t worry if this looks intimidating—we’ll break it down step by step. To make it relatable, let’s use the story of a company called Allied, which builds processing plants and sells its services.
Step-by-Step Breakdown of the Formula for Free Cash Flow
1. EBIT(1 – T): The Profit After Taxes
- EBIT stands for Earnings Before Interest and Taxes. It’s the company’s profit before paying interest on loans or taxes.
- To calculate the cash left after taxes, we multiply EBIT by (1 – T), where T is the tax rate. This is also called Net Operating Profit After Taxes (NOPAT).
In Allied’s case, EBIT is 283.8 million dollars, and the tax rate is 40%. So, NOPAT = 283.8 million × (1 – 0.4) = 170.3 million dollars.
2. Depreciation and Amortization: Non-Cash Expenses
- Depreciation and amortization reduce profits on paper but don’t involve any actual cash outflow. For example, if Allied’s machines lose value over time, that’s recorded as depreciation.
- Since this doesn’t use cash, we add it back. Allied’s depreciation and amortization for 2018 is 100 million dollars.
So far, we have: 170.3 + 100 = 270.3 million dollars
3. Capital Expenditures (CapEx): Investing in Growth
- Companies need to spend money to grow. Allied spent 230 million dollars to build a new processing plant in 2018. This is a necessary investment but reduces the cash available in the short term.
- We subtract this amount from the earlier total.
4. ΔNet Operating Working Capital (ΔNOWC): Managing Day-to-Day Cash Needs
Net Operating Working Capital (NOWC) is like the day-to-day cash a company needs to keep things running. It’s the difference between operating current assets (like inventory or accounts receivable) and operating current liabilities (like accounts payable).
For 2018, Allied’s NOWC was 800 million dollars, and for 2017, it was 650 million dollars. The change (ΔNOWC) is 800 – 650 = 150 million dollars. This means Allied needed an extra $150 million in 2018 for day-to-day operations, which reduced its Free Cash Flow ( FCF).
5. Final Calculation:
Allied’s Free Cash Flow for 2018 is -109.7 million. This means the company spent more cash than it generated.
What Does a Negative Free Cash Flow Mean?
Before you panic about Allied’s negative FCF, let’s think about why it happened. The company spent $230 million on a new processing plant. This is a big one-time expense that will help the company grow in the future. While Allied’s FCF is negative for 2018, it’s not a bad sign because:
- The new plant will meet production needs for several years.
- Allied won’t need to build another plant until 2022.
For growing companies, negative Free Cash Flow is common. They invest heavily in growth, and as long as these investments pay off, the negative FCF is temporary and strategic.
Why Does FCF Matter?
- A Positive FCF Means Flexibility: Companies with positive FCF have more options—they can reinvest, pay dividends, or save for tough times.
- A Negative FCF Isn’t Always Bad: For companies like Allied, investing in growth often leads to negative FCF. But if these investments are profitable, FCF will improve over time.
Conclusion
Free Cash Flow is one of the most important tools for evaluating a company’s financial health. It tells the real story behind the numbers—how much cash is available after all necessary expenses and investments. While a negative FCF might seem alarming, it’s often a sign of growth and strategic investments, as in Allied’s case.
Whether you’re an investor looking for the next big opportunity or a manager planning your company’s future, understanding Free Cash Flow is key to making informed decisions. So the next time you hear someone mention FCF, you’ll know they’re talking about the true heartbeat of a business!
Relevant Links:
- Understanding the Cash Flow Statement: How to Create a Cash Flow Statement with Example
- What is an Income Statement & How to Evaluate the Income Statement of a Business
- How to Organize a Balance Sheet: A Complete Guide with Examples
