Profit is an opinion, cash is a fact
Net income depends on accounting choices: how fast assets are depreciated, when revenue is recognized, which costs are capitalized. Free cash flow (FCF) cuts through this by measuring the cash actually left after the business has paid its operating costs, its taxes and the investments it needs to keep running. It is the money available to repay debt, pay dividends, buy back shares or fund acquisitions.
Two ways to calculate it
From the cash flow statement (levered free cash flow):
FCF = cash flow from operations − capital expenditures
Both figures appear in the cash flow statement of a company’s annual report (Form 10-K for US listed companies). Interest has already been paid, so this is the cash available to shareholders.
From operating income (unlevered free cash flow):
FCF = EBIT × (1 − tax rate) + depreciation and amortization − capex − increase in working capital
This version ignores how the company is financed. It is the cash flow discounted in DCF valuations to value the whole business.
Worked example
A company reports $5 million of cash flow from operations and $1.5 million of capital expenditures, on $30 million of revenue and $3 million of net income. Its market capitalization is $60 million.
- Free cash flow: $3,500,000.
- FCF margin: 3.5 ÷ 30 = 11.7% of revenue.
- Cash conversion: 3.5 ÷ 3 = 116.7% of net income.
- FCF yield: 3.5 ÷ 60 = 5.83%.
- Price to free cash flow: 17.1.
With the EBIT method, an EBIT of $4 million taxed at 21%, plus $1.2 million of depreciation, minus $1.5 million of capex and a $300,000 increase in working capital, gives $2.56 million.
Reading the ratios
- FCF margin shows how much of each dollar of sales becomes free cash. Compare it within an industry.
- Cash conversion above 100% is common for mature companies whose depreciation exceeds their capex. Persistently below 70 to 80% deserves a closer look at receivables, inventory and capitalized costs.
- FCF yield is like an earnings yield based on cash. A high yield can mean a bargain, or that the market expects cash flow to fall.
- Negative FCF is normal for fast-growing companies investing heavily, but it must be financed by debt or new equity.
Pitfalls
One year of free cash flow can be distorted by a large investment, a change in payment terms or a one-off tax payment. Look at several years, and check whether stock-based compensation, which is added back in operating cash flow, is significant.
This calculator gives estimates for education and planning. It is not investment, tax or legal advice; for decisions about your own situation, talk to a qualified financial professional.