Fundamental Analysis · Intermediate · 5 min
Free cash flow
You can calculate free cash flow from the cash flow statement, explain how it differs from net income and read a negative free cash flow in context.
Profit vs. cash
"Profit is an opinion, cash is a fact." The saying exaggerates, but it has a point. Reported profit depends on many estimates: how long a machine lasts, when a sale counts, which costs belong to which year.
Cash is harder to shape. Either it arrived in the bank account or it did not. That is why many investors look first at one number from the cash flow statement: the cash a business has left after paying for everything it needs to keep going.
Cash after investment
Free cash flow is usually calculated as:
- operating cash flow, the cash from the business itself, from the first section of the cash flow statement,
- minus capital expenditure, often called capex: the money spent on long-term assets such as machines, buildings, vehicles or software.
What is left is free in the sense that the company can choose what to do with it: repay debt, pay dividends, buy back shares, buy other companies, or keep it as a reserve.
For the fictional bicycle maker:
Why look at it next to net income? Over a single year, the two can differ a lot. Depreciation lowers profit without costing cash, while buying a new factory costs cash at once but lowers profit only gradually. Customers who pay late raise profit before they raise cash. Over many years, a healthy business turns most of its profit into cash. If profits keep rising while free cash flow does not, the reason deserves a close look.
Free cash flow is not an official accounting figure. It is a non-GAAP measure, and companies define it in different ways. Some subtract lease payments, some add back one-off items. Check the definition before comparing two companies.
Investing before earning
A negative free cash flow is not automatically a warning sign. Take a fictional company that is building two new factories.
- In years 1 and 2, its capital expenditure is larger than its operating cash flow. Free cash flow is minus 30 million, then minus 12 million.
- In year 3, the first factory is running. Free cash flow turns positive at 15 million.
- In year 4, both factories produce. Free cash flow reaches 45 million.
The question is not whether free cash flow is negative, but why, and for how long. Growth investment that pays back is very different from a business whose operations burn cash year after year. The second kind needs new loans or new shares to survive.
Common mistakes
- Comparing different definitions. One company's free cash flow may subtract leases or acquisitions, another's not. Read how it was calculated.
- Judging one year. A large investment can make free cash flow negative for a year in an otherwise healthy business.
- Ignoring where operating cash came from. Delaying payments to suppliers raises cash briefly, but cannot be repeated forever.
- Treating EBITDA as free cash flow. EBITDA ignores capital expenditure, tax and interest, so it is usually much higher.
The takeaway
Free cash flow is operating cash flow minus capital expenditure: the cash a business produces after keeping itself running and growing.
Check yourself
Quick quiz
4 questions. Instant feedback, nothing is saved.
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1Tap the line that shows the cash left after investment.
Tap the chart.
Free cash flow is operating cash flow minus capital expenditure: 90 − 40 = 50 million.
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2Operating cash flow is 120 million and capital expenditure is 70 million. What is free cash flow?
120 − 70 = 50 million.
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3A company's free cash flow is negative for two years. What is the most careful reading?
Building new capacity costs cash before it earns any. What matters is whether the investment later pays back.
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4Why do many investors look at free cash flow next to net income?
Profit depends on estimates such as depreciation. If profits rise for years while cash does not, something needs explaining.
of 4 correct.