How to Calculate Free Cash Flow and What It Means
If you have the three financial statements, including the Cash Flow Statement, it should be easy to determine a company’s “Cash Flow”: just take the “Net Change in Cash” from the bottom of the Cash Flow Statement, right?
WRONG!
The problem is that companies can spend and receive their cash in many different ways, and not all these methods are “required” and “recurring.”
For example, if a company issues Debt or Equity, both activities boost its cash flow – but neither one is necessarily “required” for the business to keep operating.
A company could spend cash buying Financial Investments, issuing Dividends, or repurchasing shares, but all those activities are also “optional.”
To estimate the company’s discretionary cash flow, therefore, we need a more precise definition.
“Discretionary cash flow” means “cash flow after the company pays for what it needs to run its business and avoid being shut down by external parties such as lenders and the government.”
We can define this metric in different ways, but a simple one is Free Cash Flow:
- Free Cash Flow = Cash Flow from Operations (CFO) – Capital Expenditures (CapEx)
There are other variations of Free Cash Flow, which we explore later in this course and the other written guides.
But this initial definition is a good one because:
- Everything in a company’s “Operating Activities” section is required for its business – earning Net Income, paying for Inventory, collecting Receivables, etc.
- But almost every line item within Investing and Financing Activities is “optional,” except for Capital Expenditures.
CapEx is a required item because companies need buildings, factories, and equipment to house employees, manufacture products, and sell them to customers.
Even companies that sell services or software need buildings and computer equipment, and spending on both of them is considered CapEx.
Free Cash Flow lets us quickly and easily assess a company’s ability to generate cash flow from its business, including the cost of servicing its Debt and other long-term funding.
How to Calculate Free Cash Flow Under IFRS and Other Accounting Systems
One important note – especially under IFRS – is that this definition assumes that Cash Flow from Operations deducts Net Interest Expense, Preferred Dividends, Taxes, and all Lease Expenses.
So, if the company you’re analyzing has a CFO section that does not do that, you will need to adjust it for comparability purposes.
For example, under IFRS, you should remove the Lease Depreciation add-back in CFO because it’s not a true “non-cash expense.”
The company still pays the full Lease Expense in cash; splitting it into Interest and Depreciation elements does not change that.
Here’s an example for Vivendi:
Also, if CFO includes many items in the Non-Cash Adjustments section besides D&A and Deferred Taxes, you may want to remove them to standardize the formula.
“How to calculate Free Cash Flow” seems like a very simple topic/formula – and it mostly is that simple under U.S. GAAP.
Because of the changes to lease accounting made in 2019, however, the calculation is often more complex for non-U.S. companies.
How to Calculate Free Cash Flow: Comparison for Best Buy and Zendesk
Here’s a quick comparison of Free Cash Flow for Best Buy (a U.S.-based retailer) and Zendesk (a U.S.-based software company):
For Best Buy, the interpretation is as follows:
FCF is positive and growing, which is good, and the company doesn’t seem to be “playing games” by artificially cutting CapEx or changing its Working Capital to boost its FCF.
In fact, the Change in Working Capital (“Changes in Operating Assets & Liabilities”) became negative in Year 3, but FCF increased anyway.
Revenue is also growing each year, so it seems like Best Buy has a healthy business whose FCF is based on growth in that core business.
For Zendesk, FCF is also positive and growing, but far more quickly than its Revenue Growth in two years.
One reason is that the Changes in Operating Assets & Liabilities are much less positive in Year 3, so FCF gets less of a boost from that.
But there’s another red flag here as well: Zendesk’s Net Income is very negative, while its FCF is positive.
Look at its statements, and you can quickly tell why:
Generally, you want to see a positive and growing FCF.
If FCF is negative, that means the company is not running a sustainable business by itself – it’s relying on outside financing to stay afloat!
That’s OK for short periods, such as the first few years of a startup’s existence, but if a company stays like that for a decade, it raises serious questions.
If FCF is negative, the first step is to ask, “Why? Is it temporary or permanent? Are the losses decreasing as the company grows?”
If FCF is becoming more negative as the company grows, stay away.
If FCF is positive, you should also ask, “Why?” before assuming it’s a good thing.
For example:
- Is the company’s FCF growing because it’s capturing more of the market, selling more, and achieving higher margins due to economies of scale? This is good.
- Is the company’s FCF growing because of creative cost-cutting, or because it’s reducing its annual CapEx spending? This is not so good.
- Is the company’s FCF growing despite falling sales, because it’s playing games with Working Capital or with CapEx and Depreciation? This is not good.
In real life, you use Free Cash Flow in the Discounted Cash Flow (DCF) analysis for valuing companies, and also in the Leveraged Buyout (LBO) analysis for assessing the acquisition and sale of a company.
You do not necessarily use the type of Free Cash Flow (CFO – CapEx) described here, but you do use variations of it.
For more on how to calculate Free Cash Flow, please see our Unlevered Free Cash Flow tutorial.
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About Brian DeChesare
Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys lifting weights, running, traveling, obsessively watching TV shows, and defeating Sauron.
