How To Calculate Free Cash Flow in 3 Steps (Plus Example)
Updated February 3, 2023
There are many ways organizational leaders and investors can calculate the expected financial health of organizations. One way they can do this is by using free cash flow (FCF). Understanding what this is and how to calculate it can help you increase your understanding of the financial position of an organization and improve your accounting skills.
In this article, we discuss free cash flow, describe how to calculate free cash flow, list the benefits of using it, and show you some of its limitations.
Free cash flow is the amount of cash available for the company to repay creditors and pay out shareholder dividends and investor interest.
Free cash flow isn't the same as cash flow, which is the net amount of funds cycling in and out of a company.
Free cash flow is also known as free cash flow to firms (FCFF).
What is free cash flow?
Free cash flow is the amount of cash an organization generates after it accounts for operational expenses and funds it uses to manage assets. FCF is used to pay investors and shareholders. Free cash flow is also called "free cash flow to firms," abbreviated as "FCFF." This number is helpful to shareholders interested in the amount of cash that an organization or investor can withdraw from an organization without disturbing operations.
FCF differs from cash flow, which appears on the cash flow statement. The key difference between the two is that cash flow is the net amount of cash or cash equivalents cycling in and out of the company. A positive or negative cash flow gives investors an understanding of how a company performs financially. FCF is only the amount left after an organization spends cash to support daily operations and capital assets like land, property and operating machinery.
Related: Guide to Cash Flow
How to calculate free cash flow
There are several ways to calculate free cash flow. The most common method of calculating FCF is by using operating cash flow in the following formula:
Free cash flow = operating cash flow − capital expenditures
Operating cash flow is the revenue an organization makes minus its operating expenses.
Capital expenditures are the money an organization uses to maintain fixed assets such as buildings, equipment or land.
Below are the steps you can use to calculate free cash flow:
1. Find financial documents
There are several financial documents you can use to calculate free cash flow. The most common document is the statement of cash flows from an organization because it already accounts for non-cash expenses and any changes in the working capital of an organization. You can also use an organization's income statement and balance sheet to calculate free cash flow because those two documents show the amount of money an organization earns and the number of expenses the organization pays during the same period. However, these documents don't adjust for changes in working capital or non-cash expenses.
2. Locate the cash flows from operating activities
You can find these values on the financial documents of an organization. This is an important part of calculating free cash flows because the operating cash flows show the amount of money an organization needs to continue its operations. Using the values from these cash flows can help you find the amount of money an organization doesn't use for operations, and determine the amount of money an investor can withdraw from a company before it disrupts operations.
3. Perform the calculation with the formula
Once you find the values for calculating the free cash flow of an organization, you can perform the calculation using the formula. For example, if an organization has an operating cash flow of $100,000 and capital expenditures (CapEx) equal to $75,000, then you can perform the following calculation:
$100,000 − $75,000 = $25,000
This value means investors can take $25,000 from an organization before it disrupts the regular operations of that organization. Investors can then use that money to invest in other organizations or reinvest the money into the original organization with the intent for the organization to use it for other processes and operations.
Benefits of using free cash flow
An organization that uses free cash flow to determine its financial health can generate a better understanding of its economic health. This is important because the organization can change how it uses money. For example, an company may reinvest its cash into creating more productive operations. An organization can also use the increased insight to determine whether the other companies with which it works send and receive payments fast enough to keep pace with the company and decide which to continue operating with and which ones it can end relationships.
An organization can use the insight from free cash flow to determine whether its operations are stable. For example, free cash flow can show an organization that made $40,000,000 in revenue over the last decade differences in its earnings for each year. While the total value may seem stable, each year's free cash flow shows the organization is relatively unstable, affecting whether investors want to place trust and money into an organization. This also allows the organization to stabilize its earnings each year, helping it become more attractive to investors, which can increase its capital.
Limitations of free cash flow
Free cash flow has some limitations, detailed below:
Limited scope: Free cash flow is limited, meaning it can only show a certain portion of the organization's capital. This is important because it can affect how some investors interact with an organization, including limiting the number of investors interested in its operations.
Depreciation: Depreciation can spread the number of large purchases throughout a large time span, for which free cash flow doesn't account. For example, a free cash flow might see the year when an organization purchased new equipment, but not the cost of the equipment as it deprecation throughout its lifetime.
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