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Free Cash Flow

Updated: Jun. 16, 2023By: Kent Thune

Free cash flow is the amount of cash a business has remaining from operations after paying capital expenditures. Find out how investors can use free cash flow to measure the financial health of a business.

Businessman working on Financial Report of corporate operations, balance

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Net Income vs. Operating Cash Flow

Although net income is an important metric, operating cash flow, also called Cash From Operations (CFO), is believed by many to be a truer measure of profitability, especially over longer periods of time. This is because CFO is less prone to the subjective application of accounting mechanisms, which can distort net income measures. Cashflow is cashflow, and decisions by the accounting department shouldn't affect the result.

Operating cashflow excludes the non-cash expenses of the income statement, but reflects other cash impacts that don't appear as income statement items, such as changes in working capital items from the balance sheet. For example, if a company has reported an increase in Accounts Receivables, this reflects that the company has received less cash than the sales reported in the income statement would imply.

What Is Free Cash Flow?

Free cash flow (FCF) is the residual amount of cash that a business has earned from its operations, over a specific period of time, less maintenance. Free cash flow can be used to pay dividends or reinvest in operations. Free cash flow analysis may be used to measure the fundamental health of a company or to calculate how much the company is worth.

Calculating Free Cash Flow: Formula

Free Cash Flow = Operating Cash Flow - Maintenance Capex

Maintenance Capex versus Depreciation and Amortization

Depreciation is a common expenses reported in company's income statement. This expense item reflects the assumed decrease in value for assets such as like manufacturing equipment. For example, if a production line for electric vehicles was purchased for $30 million, and is expected to last for 15 years, the company may recognize depreciation expense of $2 million per year, until the production line is projected to have no value. This $2 million per year amount is not a cash expense, since the company paid the $30 million cash up front. However, the income statement recognizes it as a real annual cost of doing business.

Amortization is similar to depreciation, as it reflects the regular expensing of an asset that is already reflected on a company's balance sheet. Amortization is also a non-cash deduction on a company's income statement.

Maintenance Capex (Capital Expenditure) meanwhile reflects the cash cost of purchasing new capital assets. When the hypothetical production line was purchased for $30 million, cash was paid to acquire it. However, there would have been no immediate reflection of the purchase on the company's income statement, since the value of the production line is expensed slowly, quarter after quarter, year after year, instead of being charged to the income statement in one fell swoop.

Depreciation and Maintenance Capex are closely linked. If a given company is regularly reporting $5 million in depreciation per year, and $5 million in maintenance capex per year, it would appear that the company is sustaining a stable value of assets. However, if maintenance capex was running at only $2 million per year, it could be a sign that the company isn't replacing the full economic value of assets that have depreciated.

Maintenance Capex versus Total Capital Expenditures

Companies often make capital investments that exceed the depreciated value of existing assets. Such investments are usually in pursuit of growth for the business.

So a company that conducts, for example, $12 million of capital expenditures, but where only $5 million of that is replacing lost economic value, is effectively investing an additional $7 million in growth of its asset base.

Important Note: The Capital Expenditures line reported on a company's cash flow statement doesn't usually distinguish between maintenance capex and other growth capex. If the company doesn't disclose this elsewhere, investment analysts can attempt estimates.

The capital expenditures formula is:

CapEx = Net increase in PP&E + Depreciation Expense

FCF Example

ABC Company's income statement shows a net profit of $1,000,000 after taxes last year. Our first step is to calculate operating cash flow, which means that non-cash expenses, such as amortization and depreciation, that reduced net income will need to be added back. The profit will also need to be adjusted for the change in working capital.

ABC Company's financial statements show these numbers:

  • Net Profit: $1,000,000
  • Amortization: $50,000
  • Depreciation: $100,000
  • Change In Current Assets: +$20,000
  • Change In Current Liabilities: +$80,000
  • Tangible asset purchases: $90,000

Calculate ABC Company's operating cash flow:

$1,000,000 + $50,000 + $100,000 - $20,000 + $80,000 = $1,210,000

Now calculate ABC Company's free cash flow:

$1,210,000 - $90,000 = $1,120,000

Where to Find Free Cash Flow

Free cash flow is not generally a metric that is publicly shared by corporations. Therefore, stakeholders often need to locate the inputs and make their FCF calculations. The data for FCF can be found on a company's financial statements, including the following, all of which are updated quarterly by publicly traded companies.

Bottom Line

Free cash flow can be an important way for investors to value a company because it shows how efficiently a company is generating and using cash. For example, shareholders, potential investors, or lenders may use FCF to determine the likelihood that the company will be able to pay stock dividends or interest on debt obligations.

This article was written by

Kent Thune profile picture
Kent Thune, CFP®, is a fiduciary investment advisor specializing in tactical asset allocation and portfolio management with a focus on ETFs and sector investing. Mr. Thune has 25 years of wealth management experience and has navigated clients through four bear markets and some of the most challenging economic environments in history. As a writer, Kent's articles have been seen on multiple investing and finance websites, including Seeking Alpha, Kiplinger, MarketWatch, The Motley Fool, Yahoo Finance, and The Balance. Mr. Thune's registered investment advisory firm is headquartered in Hilton Head Island, SC where he serves clients all around the United States. When not writing or advising clients, Kent spends time with his wife and two sons, plays guitar, or works on his philosophy book that he plans to publish in 2024.

Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.

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