Free cash flow

Before you rely on it

What to check

Check that capital expenditure is genuinely deducted, then look across several periods.

The common error

Where people go wrong with free cash flow

Reading one strong year as a run rate. A year of deferred maintenance produces excellent free cash flow and a bill in the following year that nobody has budgeted for.

Worked through

Free cash flow in plain numbers

A company reports net income of $600,000. Its operations generated $900,000 in cash, and it spent $350,000 on new equipment and a facility upgrade. Free cash flow is $900,000 − $350,000, or $550,000. That is the cash left after keeping the business running and growing its base, and it is what could go to dividends, buybacks, debt paydown or the bank. Notice it differs from profit. Depreciation lowers net income without using cash, and capital spending uses cash without hitting income at once; a company can report a profit and still burn cash if it invests heavily.

Easily confused

Free cash flow and its neighbours

Free cash flow is not net income, EBITDA or operating cash flow. Net income follows accounting rules and includes non-cash items. EBITDA ignores capital spending and taxes altogether. Operating cash flow includes the cash the business generates but before investment in assets. Free cash flow subtracts that investment. Levered free cash flow also subtracts interest and debt repayments, while unlevered free cash flow does not. Definitions differ between companies, so check which version is being quoted when comparing figures.

In real decisions

Where free cash flow turns up

Investors value companies on free cash flow, since it represents cash that can be returned to owners. Discounted cash flow models project it; lenders test whether it covers debt payments; managers use it to judge whether growth is self-funding. Analysts compare free cash flow yield, free cash flow divided by market value, across companies. Small business owners can use the same idea to see what cash is truly available after upkeep and purchases.

Know the edges

Where free cash flow stops being reliable

Free cash flow can swing from year to year with the timing of big investments, so a single period misleads. Cutting maintenance spending raises it for a while and hurts the business later. Working capital changes can move it sharply. It does not say whether investments were good ones. Look at several years, understand what drives the swings and compare with growth needs before drawing conclusions.

Quick answers

What people ask about free cash flow

Why is free cash flow different from net income? Net income includes non-cash items and ignores capital spending. Free cash flow starts from cash from operations and subtracts investment, so it tracks money actually available.

Can free cash flow be negative? Yes. Growing companies often spend more on investment than they generate. It is a concern only if funding runs out or the spending does not create value.

How do investors use it? They compare it with market value to get a free cash flow yield and use it in discounted cash flow valuations. It is harder to manipulate than earnings.

What is free cash flow yield? Free cash flow divided by market value. It shows the cash return per dollar invested and can be compared with bond yields.