How to Calculate Free Cash Flow
Not to be confused with cash flow from operations, free cash flow includes elements of cash flow from operations, investing, and financing. It is not found on any of the financial statements, and there are no regulatory standards dedicated to its presentation. Often referred to as a non-GAAP measure, free cash flow has many variations; however, the basic calculation is generally the same.
To calculate free cash flow, start with net income and add back depreciation and amortization. Next, subtract changes in working capital and capital expenditures. Say 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 equals $160,000.
Depreciation and amortization are considered noncash transactions, which is why they are added back to net income. The increase in working capital means more cash is being held up in working capital than the previous year or quarter, which is interpreted as an inefficient use of cash. Finally, capital expenditures are considered outflows of cash. Put together, these three line items provide you with a way to reconcile net income to free cash flow.
Mistakes to Avoid
Due to the lack of regulatory oversight, mistakes can occur in calculating free cash flow, particularly when it comes to the working capital element of the formula. Practitioners disagree on what to include or exclude given the debated definition of capital expenditure. In general, high levels of free cash flow are a positive sign of a business’s financial health, but they might also mean that your company is underreporting capital expenditures, depleting inventory, or stretching payables, for example. These activities give a boost to short-term cash flow, but at the expense of long-term business performance.
What Does Free Cash Flow Mean for Your Business
Now that you know how to calculate free cash flow, you may be wondering what it means for your business. As you can imagine, a growing free cash flow is generally a sign of growth, whereas a shrinking free cash flow can be a sign of trouble. Net income can be manipulated for a few quarters, but not free cash flow.
Growth in free cash flow is often a precursor to growth in earnings and vice versa. Your company can have 100% growth in earnings while experiencing a decline in free cash flow due to relaxed credit policies or a temporary buildup of inventory. This is why, as a precautionary measure, business owners like to focus on the drivers of free cash flow over net income.
Because free cash flow is considered a reliable indicator of business performance, financial analysts often use it to calculate the intrinsic value of a company through the discounted cash flow method. Ultimately, free cash flow refers to money that you can take out of your business and spend as you please, or invest it back into your company.