Free cash flow can be defined as the cash that a company is able to generate after spending the money required to run or expand its business. It is calculated by subtracting capital expenditures, the funds that company uses to upgrade its physical assets from operating cash flow – the cash that company spends on day-to-day expenses. Although this may sound complicated, free cash flow is actually quite simple to calculate.
Let’s look at free cash flow for Al’s Ice Cream. Al’s financial statement showed that he earned $150,000 last year. To calculate his free cash flow, Al would subtract his change in networking capital for the year – current assets minus current liabilities equaling $10,000; and his capital expenditures – $40,000 for a new ice cream machine. These numbers represent the cash that went out of the business. Finally, Al will add back any non-cash charges that reduced his net income such as depreciation or amortization – plus $20,000 + $5,000. This brings Al’s free cash flow to $125,000; $150,000 – $50,000 working capital and expenditure outlays + $25,000 in depreciation and amortization.
Free cash flow is the amount of money that companies have available for paying debt, providing dividends to investors, buying back stock and growing the business so it’s an important measure of a company’s performance. However, free cash flow can be subject to manipulation in a company’s books and is only one of the many metrics investors can use to analyze a stock.