How to Calculate Free Cash Flow (FCF)
There are three different methods to calculate free cash flow because all companies don't have the same financial statements. Regardless of the method used, the final number should be the same given the information a company provides. The three ways in which to calculate free cash flow are by using operating cash flow, using sales revenue, and using net operating profits.
Using Operating Cash Flow
Using operating cash flow to calculate free cash flow is the most common method because it is the simplest and uses two numbers that are readily found in financial statements: operating cash flow and capital expenditures. To calculate FCF, locate the item
cash flow from operations (also referred to as "operating cash" or "net cash from operating activities") from the
cash flow statement and subtract capital expenditure, which is found on the balance sheet.
The formula is:
\begin{aligned} \text{Free Cash Flow} =\ &\text{Operating Cash Flow} \ - \\ &\text{Capital Expenditures} \\ \end{aligned}Free Cash Flow=Operating Cash Flow−Capital Expenditures
Using Sales Revenue
Using sales revenue focuses on the revenue that a company generates through its business and then subtracting the costs associated with generating that revenue. This method utilizes the income statement and balance sheet as the source of information. To calculate FCF, locate sales or revenue on the income statement, subtract the sum of taxes and all operating costs (or listed as "operating expenses"), which include items such as
cost of goods sold (COGS) and
selling, general, and administrative costs (SG&A).
Finally, subtract the required investments in operating capital, also known as the net investment in operating capital, which is derived from the balance sheet.
The formula is:
\begin{aligned} &\text{Free Cash Flow} = \text{Sales Revenue} \ - \\ &\text{(Operating Costs + Taxes)} \ - \\ &\text{Required Investments in Operating Capital} \\ &\textbf{where:} \\ &\text{Required Investments in Operating Capital} = \\ &\text{Year One Total Net Operating Capital} \ - \\ &\text{Year Two Total Net Operating Capital} \\ &\textbf{and where:} \\ &\text{Total Net Operating Capital} = \\ &\text{Net Operating Working Capital} \ + \\ &\text{Net Plant, Property, and Equipment} \\ &\text{(Operating Long-Term Assets)} \\ &\textbf{and where:} \\ &\text{Net Operating Working Capital} = \\ &\text{Operating Current Assets} \ - \\ &\text{Operating Current Liabilities} \\ &\textbf{and where:} \\ &\text{Operating Current Assets} = \text{Cash} \ + \\ &\text{Accounts Receivables} + \text{Inventory} \\ &\text{Operating Current Liabilities} = \text{Accounts Payables} \ + \\ &\text{Accruals} \\ \end{aligned}Free Cash Flow=Sales Revenue−(Operating Costs + Taxes)−Required Investments in Operating Capitalwhere:Required Investments in Operating Capital=Year One Total Net Operating Capital−Year Two Total Net Operating Capitaland where:Total Net Operating Capital=Net Operating Working Capital+Net Plant, Property, and Equipment(Operating Long-Term Assets)and where:Net Operating Working Capital=Operating Current Assets−Operating Current Liabilitiesand where:Operating Current Assets=Cash+Accounts Receivables+InventoryOperating Current Liabilities=Accounts Payables+Accruals
Using Net Operating Profits
To calculate free cash flow using
net operating profits after taxes (NOPAT) is similar to the calculation of using sales revenue, but where operating income is used.
The formula is:
\begin{aligned} &\text{Free Cash Flow} = \text{Net Operating Profit After Taxes} \ - \\ &\text{Net Investment in Operating Capital} \\ &\textbf{where:} \\ &\text{Net Operating Profit After Taxes} = \text{Operating Income} \ \times \\ &\text{(1 - \text{Tax Rate})} \\ &\textbf{and where:} \\ &\text{Operating Income} = \text{Gross Profits} - \text{Operating Expenses} \\ \end{aligned}Free Cash Flow=Net Operating Profit After Taxes−Net Investment in Operating Capitalwhere:Net Operating Profit After Taxes=Operating Income×(1 - Tax Rate)and where:Operating Income=Gross Profits−Operating Expenses
The calculation for net investment in operating capital is the same as described above.
Example of Free Cash Flow Calculation
Macy's Inc. (M)
Macy's cash flow statement for the
fiscal year ending 2019, according to the company's
10K statement, indicates:1
Cash Flow From Operating Activities = $1.608 billion
Capital Expenditures = $1.157 billion
\begin{aligned} \text{Free Cash Flow} &= \$1.608 \ \text{billion} - \$1.157 \ \text{billion} \\ &= \$450 \ \text{million} \\ \end{aligned}Free Cash Flow=$1.608billion−$1.157billion=$450million
Interpreting Free Cash Flow
We can see that Macy's has a large amount of free cash flow, which can be used to pay
dividends, expand operations, and
deleverage its balance sheet (i.e., reduce debt).
From 2017 till now, Macy's capital expenditures have been increasing due to its growth in stores, while its operating cash flow has been decreasing, resulting in decreasing free cash flows.1
Growing free cash flows are frequently a prelude to increased
earnings. Companies that experience surging FCF—due to revenue growth, efficiency improvements, cost reductions, share buybacks, dividend distributions, or debt elimination—can reward investors tomorrow. That is why many in the investment community cherish FCF as a measure of value. When a firm's share price is low and free cash flow is on the rise, the odds are good that earnings and share value will soon be heading up.
By contrast, shrinking FCF might signal that companies are unable to sustain earnings growth. An insufficient FCF for earnings growth can force companies to boost debt levels or not have the
liquidity to stay in business. That being said, a shrinking FCF is not necessarily a bad thing, particularly if increasing capital expenditures are being used to invest in the growth of the company, which could increase revenues and profits in the future.
Amortization and Depreciation
To calculate free cash flow another way, locate the income statement, balance sheet, and cash flow statement. Start with net income and add back charges for
depreciation and
amortization. Make an additional adjustment for changes in
working capital, which is done by subtracting current liabilities from current assets. Then subtract capital expenditure (or spending on plants and equipment):
Net Income
+ Depreciation/Amortization
- Change in Working Capital
- Capital Expenditure
= Free Cash Flow
It might seem odd to add back depreciation/amortization since it accounts for capital spending. The reasoning behind the adjustment is that free cash flow is meant to measure money being spent right now, not transactions that happened in the past. This makes FCF a useful instrument for identifying growing companies with high up-front costs, which may eat into earnings now but have the potential to pay off later.
Free Cash Flow Benefits
Free cash flow can provide a significant amount of insight into the
financial health of a company. Because free cash flow is made up of a variety of components in the financial statement, understanding its composition can provide investors with a lot of useful information.
Of course, the higher the free cash flow the better. But we have already seen from our Macy's example that a declining free cash flow is not always bad if the reason is from further investments in the company that poise it to reap larger rewards down the line.
In addition, cash flow from operations takes into consideration increases and decreases in assets and liabilities, allowing for a deeper understanding of free cash flow. So for example, if
accounts payable continued to decrease, it would signify that a company is paying its suppliers faster. If
accounts receivable were decreasing, it would mean that a company is receiving payments from its customers faster.
Now, if accounts payable was decreasing because suppliers wanted to be paid quicker but accounts receivable was increasing because customers weren't paying quickly enough, this could result in decreased free cash flow, since money is not coming in quickly enough to meet the money going out, which could result in problems for the company down the line.
The overall benefits of a high free cash flow, however, mean that a company can pay its debts, contribute to growth, share its success with its
shareholders through dividends, and have prospects for a successful future.
Free Cash Flow Limitations
One drawback to using the free cash flow method is that capital expenditures can vary dramatically from year to year and between different industries. That's why it's critical to measure FCF over multiple periods and against the backdrop of a company's industry.
It's important to note that an exceedingly high FCF might be an indication that a company is not investing in its business properly, such as updating its plant and equipment. Conversely, negative FCF might not necessarily mean a company is in financial trouble, but rather, investing heavily in expanding its
market share, which would likely lead to future growth.
Value investors often look for companies with high or improving cash flows but with undervalued
share prices. Rising cash flow is often seen as an indicator that future growth is likely.
