Understanding free cash flow (FCF): Definition, Formula and Examples

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Cash Flow

What is free cash flow (FCF)?

Free cash flow is your go-to liquidity – the cash that a business has available to pay debts, buy assets (such as stock or property), or pay shareholders’ dividends and interest. It doesn’t include the company’s value towards any ownership rights such as property, stock, equipment, licensing, or patent rights.

The free cash flow formula is calculated as operating income minus capital expenses. Essentially, free cash flow is the amount of money that a business can produce immediately. Although not a representation of a company’s total value, it’s a good measure of its financial performance and whether you have the cash you need to meet short-term financial obligations or if you need to look for small business financing.

Read on for tips on how to calculate it, and how you can improve your business cash flow performance.

Why does free cash flow matter?

Free cash flow (FCF) is crucial for any business, acting as a barometer of financial health and a driver for future growth. Here’s why it matters:

Fuel for Expansion: Free cash flow provides the necessary funds for a business to expand its operations and pursue new ventures without relying heavily on external financing. Whether it’s opening a new branch, investing in new technology, or hiring additional staff, FCF gives businesses the flexibility to grow and innovate.
Investment Opportunities: With ample free cash flow, a business can confidently pursue both short-term and long-term investment opportunities. This might include capital investments in equipment, research and development for new products, or strategic acquisitions to enter new markets or strengthen its market position.
Debt Management: Free cash flow is essential for managing and paying off debt. Businesses with healthy FCF can reduce their debt load, lowering interest expenses and improving their credit rating. This not only strengthens the balance sheet but also provides more leeway to negotiate better terms for future borrowing.
Shareholder Returns: FCF allows businesses to reward their shareholders by paying dividends or buying back shares. These actions can enhance shareholder value and demonstrate the company's financial stability and commitment to returning value to its investors.
Financial Security: Having robust free cash flow acts as a financial buffer during economic downturns or unexpected challenges. It ensures that the business can continue to operate smoothly, covering operational expenses and other obligations even in tough times.
Strategic Flexibility: Businesses can quickly seize new opportunities or pivot when market conditions change. It enables a proactive rather than reactive approach to business management.
Enhancing Business Value: Investors often look at free cash flow to assess the intrinsic value of a business. Consistent and growing FCF is a strong indicator of a company’s ability to generate cash and create value over the long term, making it more attractive to potential investors and buyers.

Free cash flow formula

To calculate the free cash flow available for your business, use the formula below:

Operating cash flow – capital expenditures

How to calculate free cash flow

Here’s a step-by-step guide on how to calculate the free cash flow for your company:

Calculate the total revenue/earnings for the calendar year.
Calculate taxes paid for that year.
Calculate expenses for the same calendar year.
Calculate revenue - taxes - expenses.
The remaining total will be the free cash flow of your company at the end of the calendar year.

Free cash flow example

Now that we understand the free cash flow formula, let’s look at an example using a UK-based company. Free cash flow can be calculated using three key figures: net income, total depreciation and amortisation, and capital expenditure. Suppose a company has the following data for its most recent fiscal year:

Net income: £50 million
Depreciation & Amortisation: £20 million
Capital Expenditures: £30 million

As we know, the company’s free cash flow is calculated as follows:

‍Free Cash Flow=Operating Cash Flow−Capital Expenditures

= (net income + depreciation & amortisation) – capital expenditures

So:

(£50 million+£20 million)−£30 million

Therefore, the company's free cash flow is £40 million. This indicates that after covering all expenses, the company has £40 million remaining to pay dividends, buy back shares, or invest in new projects and capital assets.

Free Cash Flow FAQs

What is unlevered free cash flow?

Unlevered free cash flow is the amount of available cash that a business has available before accounting for its various financial obligations. This financial obligation includes paying off any debts, interest, or shareholder dividends.

What is levered free cash flow?

Levered free cash flow refers to the amount of money that a business has remaining after paying its financial obligations. It’s widely considered the most vital figure for investors to take a look at because it’s a good indicator of company profits.

How to calculate free cash flow yield?

Free cash flow yield is a key financial solvency ratio that indicates how efficiently a company generates cash relative to its share price.

To calculate your company’s free cash flow yield, divide the free cash flow per share by the current share price. This ratio provides insight into the value a company is generating for its shareholders through its operational efficiency and cash generation capabilities.

How to convert free cash flow to firm?

Free cash flow to firm (FCFF) shows the cash that is available to all funding providers. This may include common stakeholders, preferred stakeholders, debt holders, and more. The usual starting point when calculating FCFF is to obtain net operating profit after tax (NOPAT). All non-cash expenses are then removed, alongside capital expenditure and changes in net working capital. FCFF can also be referred to as unlevered cash flow (which we mentioned above).

Short Term Finance To Manage Your Cash Flow

Managing cash flow and working capital requires finance flexibility. That’s why iwoca’s Flexi-Loan offers same day access to funds with quick decisions, flexible terms and full transparency to help SMEs cover unexpected expenses, and invest in growth opportunities.

Calculate how much you could borrow and get a same day decision here.

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