A publicly traded company reports earnings on a regular basis to inform investors about the progress of its business. At the most basic level, investors want to know if the company was profitable and, if so, whether net income rose, fell, or was little changed. But net income—typically what’s left when expenses are subtracted from revenue—can be skewed by sales that are recorded now, though no cash has changed hands yet, or by possible future losses when an asset declines in value on paper.
Cash flow, in contrast, only counts money the company actually takes in and pays out. Cash flow is a hard-money test of a company’s performance, a reality check on reported earnings.
What is free cash flow?
Free cash flow is the amount of cash a company has left after it has paid all expenses, including expenses for maintaining its business. Such expenses are called capital expenditures. When a company replaces or updates an old factory, or invests in a new computer system, for example, those are capital expenditures.
Cash flow is compared against net income in an exercise to reconcile the two—net income may include non-cash expenses, which are added back to cash flow from operations. For example, imagine Company A had net income of $100 million that included a $20 million non-cash charge for depreciation. The depreciation might reflect the wear and tear on a fleet of trucks or aging machinery on an assembly line, based on estimates of their declining potential to produce income. In the cash flow equation, the $20 million would be added back because the company didn’t actually pay out $20 million in cash.
Free cash flow vs. net cash flow: What’s the difference?
Free cash flow focuses on how much cash a company generates from its business operations, after subtracting operating expenses and capital spending.
Net cash flow is a broader accounting of the three parts of a company’s cash flow: cash from operations, cash from investing, and cash from financing. Examples of cash flow from investing would be capital spending for assets (outflow) or asset sales (inflow). Financing cash flows include dividend payments (outflow) or proceeds from the sale of stock or bonds (inflow).
How free cash flow is calculated
Companies don’t report free cash flow as a specific line item in financial statements. Rather, it must be calculated from other line items that appear among the following three corporate financial statements:
- Income statement. This is typically referred to as the earnings report. It includes total sales or revenue, expenses (cash and non-cash), and net income.
- Balance sheet. This lists a company’s assets, liabilities, and the difference between them, or the company’s net worth, which is also known as shareholders’ equity. Capital expenditures can be derived from the balance sheet and income statement.
- Cash flows. This tracks only the money received and paid by the company. There are three sections showing the sources of cash flow: business operations, investing, and financing. Cash flow from operations is the most important, as it shows whether the company is generating enough money from the business to pay its expenses. Capital expenditures appear in the cash flow from investing section.
Investors have a few ways of figuring out free cash flow, depending on how a company presents its three financial statements.
The simplest and most frequently used method starts with the consolidated statement of cash flows and the line item called net cash from operations or operating activities. Then go to another line item: net cash from investing activities. Free cash flow is:
Net cash from operating activities - net cash from investing activities = free cash flow
So for example, if ABC Corp. had $200 million net cash from operations in 2021, and invested $100 million to upgrade property, plant, and equipment, its free cash flow for 2021 was:
$200 million - $100 million = $100 million
Alternatively, an investor could determine free cash flow by first going to the balance sheet and the line item: net purchases of property, plant, and equipment. Then in the income statement, find the line item: depreciation (or depreciation and amortization), and add the two. Free cash flow then is:Net purchases of property, plant, equipment + depreciation = free cash flowOther methods are sometimes used by analysts and fund managers to determine free cash flow, requiring closer examination and dissection of financial statements. This is because companies can vary how they present their financial statements and describe line items, so there is no single formula that works for all companies.
How companies use free cash flow
Free cash flow allows companies to spend on opportunities for growth such as expansions or acquisitions, and to increase shareholder value by reducing debt, paying dividends, or buying back stock.
For example, Microsoft in January 2022 agreed to pay cash for its almost $69 billion acquisition of video-game producer Activision Blizzard, and Google parent Alphabet in April 2022 said it planned to spend $70 billion in cash on stock buybacks over time. In recent years, Apple, Microsoft, and Facebook parent Meta also have announced huge share buybacks, to be paid from free cash flow.
Meanwhile, Amazon’s climbing costs for shipping and logistics, along with rising overhead, resulted in several quarters of negative free cash flow starting in early 2021, a reversal from record positive free cash flow of $31 billion in 2020.
Low or negative free cash flow may force a company to seek outside financing to keep growing, which has potential drawbacks. Debt financing creates additional costs in the form of interest payments, while raising money by selling more shares dilutes the stake of current shareholders.
Investors like companies with large or growing free cash flow because it often is a precursor to higher earnings. Value investors particularly are attracted to companies with low share prices relative to free cash flow.
Is free cash flow a good measure of a company’s performance?
Many professional investors and fund managers focus on free cash flow as a better indicator of financial performance than earnings, which can be diminished or magnified through non-cash adjustments, some of which are at the discretion of a company’s management. A company with positive free cash flow is capable of sustaining itself, without needing outside financing.
Limitations of free cash flow
Although free cash flow is a key measure of a company’s financial health, it may be less useful when viewed in isolation. Among its potential limitations:
- High free cash flow. This isn’t necessarily a good thing, and it may indicate that a company is accumulating too much cash and not finding ways to invest it. For instance, a company might be postponing necessary capital spending to upgrade or replace old assets, which could reduce its ability to generate sales and earnings in the future.
- Low free cash flow. Conversely, this doesn’t necessarily signify that a company is in trouble. If it’s using cash to expand and gain market share in its industry, that can spur future growth.
- Trends. Changes in free cash flow may be more important than the amount of free cash flow in a particular period. For instance, if a company’s free cash flow has followed a pattern relative to earnings, then suddenly drops, investors can examine the circumstances. The company may have spent on some important upgrades that eventually restore free cash flow to past or higher levels.
- Industry variations. Free cash flow varies by industry, so comparisons among similar companies may be more relevant. A capital-intensive company such as an automaker or energy producer will have very different free cash flow than, say, a retailer. Free cash flow also is more appropriate when evaluating non-financial companies such as manufacturers and providers of services, which have large amounts of fixed assets and well-defined capital expenditures. It’s less relevant for banks and financial companies.
The bottom line
Free cash flow shows how much money a company has at its disposal after all costs, including capital spending, to maintain business operations. It is examined along with other measures such as earnings and return on investment (ROI) to gauge a company’s financial condition. Investors are attracted to companies with strong free cash flow because it indicates that a business has money to use for expansion, acquire other companies, reduce debt, pay dividends, or buy back stock.