How to Calculate Free Cash Flow
What does free cash flow measure? Not to be confused with cash flow from operations, free cash flow includes elements of your business’s cash flow from operations, investing, and financing. It is not found on any of the financial statements, and there are no regulatory standards that dictate its calculation. Often referred to as a non-GAAP measure, free cash flow has many variations, but the basic calculation is generally the same.
Free cash flow is a measure of a company’s financial performance. It represents the cash that a company is able to spend on paying dividends or accumulate on its balance sheet after spending the necessary funds to maintain or grow its asset base. Free cash flow is an important measure because it gives the company choices: stash the cash in a reserve fund, buy back shares of outstanding stock, or pay dividends.
To learn how to calculate free cash flow , start with net income and add back any asset depreciation and amortization. Next, subtract changes in working capital and capital expenditures. For example, you have $200,000 in net income and $10,000 in depreciation. You also have a $50,000 increase in working capital and a $40,000 investment in capital expenditures. The calculation looks like this:
- Net income = $200,000
- Add depreciation or amortization +$50,000
- Subtract changes in working capital accounts -$50,000
- Subtract capital expenditures -$40,000
- Free cash flow = $160,000
Depreciation and amortization are considered non-cash transactions, which is why they are added back to net income, and capital expenditures are considered outflows of cash. All together, these three line items provide you with a way to reconcile net income to free cash flow.