What is Free Cash Flow and Why Should You Care?
Free Cash Flow (FCF) gives a clearer picture of a company's financial health than net income alone. Unlike profit figures that include non-cash items, FCF shows the actual cash a company has available after funding operations and maintaining or expanding its asset base.
Investors favor FCF because it indicates how much cash a company can use for dividends, debt reduction, acquisitions, or reinvestment. A company with healthy Free Cash Flow is typically more stable and financially flexible.
How to Calculate Free Cash Flow
The formula is:
$$\text{FCF} = (\text{Net Income} + \text{Depreciation} - \Delta\text{WC}) - \text{CapEx}$$
Where:
- Net Income is profit after all expenses and taxes
- Depreciation is the non-cash reduction in asset value
- Change in Working Capital is the change in current assets minus current liabilities
- Capital Expenditure is spending on fixed assets like property and equipment
Calculation Example
Consider a company with:
- Net Income: $100,000
- Depreciation: $20,000
- Change in Working Capital: $10,000
- Capital Expenditure: $30,000
Step 1: Add depreciation to net income:
$$100000 + 20000 = 120000$$
Step 2: Subtract change in working capital:
$$120000 - 10000 = 110000$$
Step 3: Subtract capital expenditure:
$$110000 - 30000 = 80000$$
The Free Cash Flow is $80,000.
Summary Table
| Metric | Value |
|---|---|
| Net Income | $100,000 |
| Depreciation | $20,000 |
| Change in Working Capital | $10,000 |
| Capital Expenditure | $30,000 |
| Free Cash Flow | $80,000 |
Understanding Free Cash Flow helps investors evaluate companies beyond simple profit metrics and assess their true cash-generating ability.