Free cash flow (FCF): what makes it different and how to calculate it
Calculating free cash flow shows how much money a business has left over after subtracting operating expenses. Learn more about how this figure can help track financial health. Presented by Chase for Business.
- Free cash flow (FCF) is calculated by subtracting capital expenditures from operating cash flow (though analysts may make adjustments to account for interest expenses, taxes and non-cash items).
- Unlike operating cash flow, free cash flow subtracts capital expenditures, making it a more precise measure of cash available for strategic decisions like paying down debt, funding growth or distributing dividends.
- Consistently positive free cash flow may signal strong financial health, but it should be reviewed alongside operating cash flow and net income for a complete picture of business performance.
Whether you are a business owner trying to fund an expansion, an investor evaluating a stock's dividend safety or a financial analyst building a valuation model, understanding FCF and how it differs from general cash flow may provide valuable insights. In this guide, we’ll discuss what FCF is, how to calculate it and what it may reveal about a company’s financial health.
What is free cash flow and how is it different?
Unlike general cash flow measures, FCF is the amount of cash a business has remaining after all core operating expenses and investments needed to maintain or grow operations have been paid. In simple terms, it shows the true discretionary cash left over after covering everyday bills and investing in long-term assets like equipment or facility upgrades.
This cash can be deployed in several ways. A business might use it to fund acquisitions, reduce debt, pay dividends or build a reserve for economic downturns. What sets FCF apart is that it can strip away accounting adjustments to help highlight the actual cash on hand for making strategic decisions.
Operating cash flow vs. free cash flow
Free cash flow sounds similar but should not be confused with operating cash flow. While both metrics measure the cash moving through a business, they can tell two different stories.
The primary difference comes down to capital expenditures—the money a company spends to buy, maintain or improve its fixed assets:
- Operating cash flow measures the cash generated strictly from normal, day-to-day business operations. It accounts for net income, adjusts for non-cash expenses like depreciation and factors in changes in working capital. It can help tell you if the core business engine is profitable.
- Free cash flow goes a step further by deducting capital expenditures. It recognizes that maintaining equipment or buying new machinery is often a necessary cost of doing business.
In short, operating cash flow may show how much cash the business produces, while FCF shows how much of that cash might be removed from the business without harming its future operations.
How to calculate free cash flow
While financial professionals use various models, the most common and straightforward free cash flow formula is:
Free cash flow = Operating cash flow − Capital expenditures
To calculate FCF, subtract the capital expenditures from the operating cash flow. Operating cash flow is often listed near the top of a company’s cash flow statement.
Depending on the depth of analysis required, financial analysts may adjust this basic formula to factor in interest expenses, taxes and complex non-cash items like stock-based compensation.
What free cash flow tells you about your business
FCF can be a clear indicator of financial health and adaptability. Consistently positive FCF may indicate efficient management and a healthy cash position. Negative FCF typically means expenses and investments outpace the cash coming in.
While negative FCF may require scrutiny, it’s not always a red flag. For instance, a manufacturing company might show negative FCF during a year when it purchases a major piece of machinery to double its production capacity. In cases like these, the negative FCF may be a deliberate investment in future growth.
Benefits and limitations of free cash flow
Benefits of calculating free cash flow
Calculating FCF can be beneficial for a company because it often provides a clearer picture of true liquidity than operating cash flow or net income metrics. While an income statement might show record profits, FCF reveals the actual cash available after a business pays for its day-to-day operations and necessary capital expenditures.
Knowing FCF metrics can offer advantages to business owners and investors:
- Highlights financial flexibility: It can show how much cash is free to use for investments, debt repayment or owner distributions.
- Informs important decisions: Understanding FCF may help guide choices about expanding, acquiring competitors or reducing leverage.
- Appeals to investors and lenders: Strong FCF is often a primary metric banks use to help approve loans and investors use to screen for resilient stocks.
- Adds depth to financial analysis: Unlike operating cash flow, FCF accounts for capital expenditures, giving a more complete picture of actual liquidity.
Limitations of calculating free cash flow
Despite its benefits, using FCF as a business metric has some potential limitations in its use and interpretations, including:
- High volatility: FCF can vary widely from one period to the next. A major equipment purchase can drive FCF negative in a single year even if the underlying business is highly profitable.
- Lack of standardization: Unlike operating cash flow, companies may define capital expenditures differently, making it difficult to compare FCF across different organizations.
- Incomplete picture: FCF may best be used as one of several financial tools, not as the sole measure of performance.
Strategies for improving free cash flow
There isn’t a single number that is indicative of good or healthy FCF, but generally, this is a number that businesses would want to increase. Increasing FCF typically requires optimizing both cash inflows and outflows.
Practical approaches may include increasing operating cash flow and reducing or optimizing capital expenditures:
Increasing operating cash flow
- Improving profit margins by reducing overhead
- Accelerating receivables collection to bring cash in faster
- Reducing inventory carrying costs to free up working capital
Reducing or optimizing capital expenditures
- Considering leasing equipment instead of purchasing
- Phasing large capital purchases over multiple periods
- Evaluating whether capital spending is generating sufficient return
By actively managing these areas, a business may be able to strengthen its cash position and remain agile.
Frequently asked questions
What is the difference between free cash flow and operating cash flow?
Operating cash flow measures the cash a company generates strictly from its regular business operations. Free cash flow takes this a step further by subtracting capital expenditures—such as purchases of property or equipment—from the operating cash flow to represent the actual cash a business has left over.
What is the difference between free cash flow and profit?
Profit is an accounting measure of total earnings after expenses, while free cash flow can indicate how much actual liquidity remains after covering operating and capital costs.
How often should free cash flow be calculated?
Many companies and analysts review free cash flow monthly or quarterly to closely monitor financial health and spot emerging trends.
Is a negative free cash flow a problem?
Not always. Negative free cash flow may simply reflect deliberate investments in long-term growth. If it persists without a clear strategic reason, it may require further analysis of business operations.
What are some common mistakes when calculating free cash flow?
Frequent errors may include misclassifying operating expenses, overlooking capital investments or failing to account for changes in working capital.
