Free cash flow is the amount of operating cash flow which remains after subtracting capital expenditures.
Free cash flow is a measure of a company’s residual cash profits. However, free cash flow differs from profit on the income statement in several respects. First, free cash flow incorporates the cash flow effects of increases in operating working capital. Operating working capital is the sum of current operating assets, such receivables and inventory, minus the sum of current operating liabilities, such as payables. An increase in operating working capital decreases cash flow relative to accounting profits. A decrease in operating working capital increases cash flow relative to accounting profits. The second difference between free cash flow and accounting profits is that free cash flow ignores non-cash charges, such as depreciation, amortization, and impairment charges. And third, free cash flow subtracts fixed asset purchases, known as capital expenditures.
Free cash is “free” in the sense that it is the cash flow available for discretionary purposes. Public companies have five potential uses of free cash flow: (1) invest in growth, (2) acquire other companies, (3) reduce outstanding debt, (4) pay dividends, or (5) repurchase stock shares. Private companies, that is companies which are not listed on a stock exchange, generally cannot repurchase outstanding stock (or it is impractical to do so).
The narrowest calculation for free cash flow is to subtract net capital expenditures from operating cash flow. This is a relatively easy calculation, as both operating cash flow and capital expenditures appear explicitly on the company’s statement of cash flows. However, more nuanced calculations of free cash flow exist.
Financial professionals, such as stock analysts and commercial bankers, often rely on free cash flow forecasts to assess the attractiveness of a stock investment or debt issuance.
