Which of the following cash flows is not a free cash flow associated with a project?

The free cash flow calculation tells a company how much cash it is generating after paying the costs of remaining in business. In other words, it lets business owners know how much money they have to spend at their discretion. It's a key indicator of a company's financial health and desirability to investors.

Here's how to calculate free cash flow, and why it matters to both businesses and investors.

What Is Free Cash Flow?

Free cash flow refers to how much money a business has left over after it has paid for everything it needs to continue operating—including buildings, equipment, payroll, taxes, and inventory. The company is free to use these funds as it sees fit.

Businesses calculate free cash flow to guide key business decisions, such as whether to expand or invest in ways to reduce operating costs. Investors use free cash flow calculations to check for accounting fraud—these numbers aren't as easy to manipulate as earnings per share or net income. Free cash flow also gives investors an idea of how much money could possibly be distributed in the form of share buybacks or dividend payments.

How Do You Calculate Free Cash Flow?

There are several ways to calculate free cash flow, but they should all give you the same result. Not all companies make the same financial information available, so investors and analysts use the method of calculating free cash flow that fits the data they have access to. The simplest way to calculate free cash flow is to subtract a business's capital expenditures from its operating cash flow.

If you're analyzing a company that doesn't list capital expenditures and operating cash flow, there are similar equations that determine the same information, such as:

• Free cash flow = sales revenue - (operating costs + taxes) - required investments in operating capital
• Free cash flow = net operating profit after taxes - net investment in operating capital

How Free Cash Flow Works

Positive free cash flow is indicative of overall business health. Companies that have a healthy free cash flow have enough funds on hand to meet their bills every month—and then some. A company with rising or consistently high free cash flow is generally doing well and might want to consider expanding. A company with falling or consistently low free cash flow might need to restructure because there's little money remaining after covering the bills.

It's not unusual for investors to look for companies with rapidly rising free cash flow because such companies tend to have excellent prospects. If investors find a company with rising cash flow and an undervalued share price, it is a good investment and maybe even an acquisition target.

Limitations of Free Cash Flow

Low free cash flow is not always indicative of a failing business. Even healthy companies see a dip in free cash flow when they're actively pursuing growth. Corporate moves like acquisitions and investments in new product development temporarily subtract from the bottom line.

Try to look beyond the numbers. Keep in mind that older, more established companies tend to have more consistent free cash flow, while new businesses are typically in a position where they're pouring money into stabilization and growth. The company's industry also plays a large role in determining free cash flow—not every business needs to spend money on equipment, land, or inventory.

Note

Free cash flow is a better indicator of corporate financial health when measuring nonfinancial enterprises, such as manufacturing or service firms, rather than investment firms or banks. It all depends on the kinds of fixed assets that are required to operate in a given industry.

Though more foolproof than some other calculations, free cash flow is not completely immune to accounting trickery. Regulatory authorities haven't set a standard calculation method, so there is some wiggle room for accountants. For example, accounts can manipulate when accounts receivable and accounts payable are received, made, and recorded to boost free cash flow.

Key Takeaways

• Free cash flow measures how much cash a company has at its disposal, after covering the costs associated with remaining in business.
• The simplest way to calculate free cash flow is to subtract capital expenditures from operating cash flow.
• Analysts may have to do additional or slightly altered calculations depending on the data at their disposal.
• Free cash flow is best used to analyze nonfinancial companies with clear capital expenditures such as warehouses, inventory, and manufacturing equipment.

The cash left after making investments in capital assets

What is a Free Cash Flow?

Free cash flow (FCF) measures a company’s financial performance. It shows the cash that a company can produce after deducting the purchase of assets such as property, equipment, and other major investments from its operating cash flow. In other words, FCF measures a company’s ability to produce what investors care most about: cash that’s available to be distributed in a discretionary way.

Types of Free Cash Flow

When someone refers to FCF, it is not always clear what they mean.  There are several different metrics that people could be referring to.

The most common types include:

1. Free Cash Flow to the Firm (FCFF), also referred to as “unlevered”
2. Free Cash Flow to Equity, also knows as “levered”

To learn more about the various types, see our ultimate cash flow guide.

Importance of Free Cash Flow

Knowing the company’s free cash flow enables management to decide on future ventures that would improve the shareholder value. Additionally, having an abundant FCF indicates that a company is capable of paying its monthly dues. Companies can also use their FCF to expand business operations or pursue other short-term investments.

Compared to earnings per se, free cash flow is more transparent in showing the company’s potential to produce cash and profits.

Meanwhile, other entities looking to invest may likely consider companies that have a healthy free cash flow because of a promising future. Couple this with a low-valued share price, investors can generally make good investments with companies that have high FCF. Other investors greatly consider FCF compared to other measures because it also serves as an important basis for stock pricing.

How is FCF Calculated?

There are various ways to compute for FCF, although they should all give the same results. The formula below is a simple and the most commonly used formula for levered free cash flow:

Free Cash Flow = Operating Cash Flow (CFO) – Capital Expenditures

Most information needed to compute a company’s FCF is on the cash flow statement. As an example, let Company A have $22 million dollars of cash from its business operations and $6.5 million dollars used for capital expenditures, net of changes in working capital. Company A’s FCF is then computed as:

FCF = $22 – $6.5 = $15.5m

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Limitations Associated with Free Cash Flow

The company’s net income greatly affects a company’s free cash flow because it also influences a company’s ability to generate cash from operations. As such, other activities (i.e., those not within the core business operations of a company) from which the company generates income must be scrutinized deeply in order to reflect a more appropriate FCF value.

On the investors’ side, they must be wary of a company’s policies that affect their declaration of FCF. For example, some companies lengthen the time to settle their debts to maintain cash or, the opposite, shortening the time they collect debts due to them. Companies also have different guidelines on which assets they declare as capital expenditures, thus affecting the computation of FCF.

Applications in Financial Modeling

For professionals working in investment banking, equity research, corporate development, financial planning & analysis (FP&A), or other areas of corporate finance, it’s very important to have a solid understanding of how FCF is used in financial modeling.

Discounted Cash Flow, or DCF models, are based on the premise that investors are entitled to the free cash flow of a firm, and therefore the model is based solely on the timing and the amount of those cash flows.

To learn more about DCF modeling, check out CFI’s online financial modeling courses.

Screenshot from CFI’s financial modeling course.

Additional Resources

Thank you for reading CFI’s guide to Free Cash Flow (FCF). To keep learning and advance your career, the following resources will be helpful:

• Unlevered Free Cash Flow
• EBITDA
• FCF vs FCFF vs EBITDA
• Financial Modeling Guide

What are the 4 types of cash flows?

What are the types of free cash flow?

What is included in free cash flow?

Which of the following is not part of cash flow activity?