• Skip to main content
  • Skip to secondary menu
  • Skip to primary sidebar
  • Skip to footer

Your Finance Book

Income Tax | Investing | Stock Market

  • Stocks
    • 10 reasons why share prices decline in the stock market
    • What to look for in growth investing strategy for better return
    • 10 things you must understand before buying stocks
    • Speculating Vs Investing Vs Saving
    • A beginner’s guide to understand stock’s value – Explained with examples
    • Mutual Fund Basics
  • GST
    • GST registration in India – all you need to know
    • Tax invoice in GST-A complete beginner’s guide for taxpayers
    • Input tax credit in GST – A beginners guide to claim ITC
    • What is inter-state supply of goods and/or services under GST
    • What is intra-state supply of goods and/or services under GST
  • Income tax
  • Tax Rates
  • ITR Due dates
  • About Us
  • Privacy Policy
  • Disclaimer
  • Terms of Use and Policies
  • Contact Us
Home / Finance / Free cash flow (FCF): How to calculate and interpret

Free cash flow (FCF): How to calculate and interpret

Last updated on January 10, 2024 by CA Bigyan Kumar Mishra

Share
Share on Facebook
Pin
Pin this
Share
Share this
Share
Share on LinkedIn

Free cash flow (FCF) means the amount of cash remaining with the company after paying for its operating costs, inventory and to buy fixed assets. Which means the cash flow from operating activities minus capital expenditures during the financial year.

We can also define free cash flow as the amount of money the company has generated after accounting all cash outflows that support its operations and maintain its capital assets.

Capital expenditure is the money spent on new investments to replace, expand or modernize long term operating assets of the company.

Below in this article, we will show you how to calculate free cash flow and what it indicates. You will also learn why institutional investors consider free cash flow instead of net earnings.

free cash flow

What Free Cash Flow (FCF) indicates?

Cash left with the company after deducting operating and capital expenditures is available for free use.

If free cash flow is negative, then it indicates that the company’s total cash outlays for expenses is more than it’s cash inflow from revenue.

Free cash flow number is not reported on the income statement.

Earnings before interest, tax, depreciation and amortization (EBITDA) is considered as free cash flow by the financial analysts in order to know how efficiently the company can cover its debt service.

Otherwise, the following formula can be used to calculate free cash flow (FCF) of an organization.

Formula used to calculate free cash flow (FCF)

Free cash flow (FCF) is not a line item listed in the income statement, or in any other financial statements. You have to calculate free cash flow by using line items found in the financial statements.

As discussed above, FCF is the money a company has left over after paying its operating and capital expenditures.

Therefore, Free cash flow = net operating profit after tax for the year – capital expenditure made during the year

Above formula is used when you have a company’s cash flow statement. It’s the easiest way to calculate FCF. Both capital expenditure and operating cash flow can be found in the cash flow statement.

We have one more method to calculate free cash flow. Both calculations should give you the same result.

In the second method, you need to take net operating profit after tax from the company’s income statement to calculate free cash flow. Here is the formula used to calculate FCF;

Free cash flow = Net operating profit after tax – net investment in operating capital

Net operating profit after tax = (Gross profit – operating expenses) * (1-tax rate)

Net investment in operating capital = net operating working capital + net plant, property, and equipment

If you don’t have gross profit to calculate net operating profit, then you can use the following formula to calculate FCF.

FCF = Net income after tax + Depreciation and amortization – Change in working capital – Capital expenditures

Why Free cash flow (FCF) is used?

Knowing how to calculate free cash flow helps the company’s management to manage cash effectively. It shows the efficiency of the management in generating cash. 

To investors FCF helps to make better investment decisions. They calculate FCF to know whether the company has enough cash to pay debt, invest in opportunities that can enhance its business and reward its shareholders.

Higher free cash flow indicates that the company has more money that can be allocated to paying down debt, dividends, and growth opportunities.

Shrinking FCF might signal that the company is unable to sustain earnings growth. You need to look into the real reason behind the decline in FCF. If shrinking in free cash flow is due to increase in capital expenditure, then it’s a good thing as new investments might increase revenues and profits in the future.

Remember, free cash flow is just one fundamental indicator used to understand a company’s financial health. You need a complete fundamental analysis to understand the financial position. 

Following financial tools might help you to analyse financial statements of a company;

  • Return on investment (ROI)
  • Debt to equity ratio (D/E)
  • Earnings per share (EPS)
  • Price to earnings ratio (P/E)
  • Liquidity ratios
  • Profitability ratios
  • Solvency ratios
  • Turnover ratios

Limitations of Free Cash Flow (FCF)

One of the biggest drawbacks of free cash flow is that it’s not a comparable measure.

FCF may increase or decrease year on year depending on how the company has invested in capex. Similarly a company with same profit with less capex might have higher FCF in comparison to a company which has higher capex.  Investing heavily on capex might increase the company’s future earnings, profit and market share.

Now you know what free cash flow is, how to calculate and interpret it. If you like this article, don’t forget to share it and subscribe to our newsletter.

Share
Share on Facebook
Pin
Pin this
Share
Share this
Share
Share on LinkedIn

Categories: Finance

About the Author

CA Bigyan Kumar Mishra is a fellow member of the Institute of Chartered Accountants of India. He writes about personal finance, income tax, goods and services tax (GST), company law and other topics on finance. Follow him on facebook or instagram or twitter.

Primary Sidebar

Financial Ratios

  • The 5 Best Investing Books for Beginners
  • Accounting tools you can use to choose a winning stocks
  • What are the tools and techniques used in financial statements analysis
  • Can Price to earnings – P/E ratio be used for stock investing
  • Why Price earnings to growth – PEG is used by investors
  • How Earnings per Share or EPS can help you
  • How to use debt to equity – D/E ratio
  • What is Interest coverage ratio

Don’t see a topic? Search our entire website:

Footer

Trending Now

  • What to look for in the financial statements before investing in stocks
  • How to manage fund while investing in stocks
  • A beginner’s guide to mutual fund investing
  • Why share prices move up and down in stock market
  • Price Action trading – How candlestick helps to read mass psychology

Email Newsletter

Sign up to receive email updates daily and to hear what's going on with us!

Privacy Policy

Stay In Touch With Us

  • Twitter
  • Facebook

Legal Disclaimer

The information available through this Site is provided solely for informational purposes on an “as is” basis at user’s sole risk. The information is not meant to be, and should not be construed as advice or used for investment purposes. Yourfinancebook.com does not provide tax, investment or financial services and advice. We make no guarantees … Continue Reading... about Disclaimer

Copyright © 2024 yourfinancebook.com · All Rights Reserved.