What are Free Cash Flows and how to Calculate them
Free cash flows is the cash left after subtracting for capital expenditures, FCF=CFO-CapEx
Free cash flows represent the generated cash which belongs to owners1 of a company. To calculate it, we need to find the cash from operating activities and subtract capital spending.
We use cash from operating activities because it is after expenses2 have been subtracted from revenues. Then we subtract the capital expenditures because that represents cash leaving the business to fund growth investments - think buying property for a factory or new machinery.
Note for non-beginners: This article only explains basic FCF, which is a simplification of free cash flows to the firm (FCFF). If you are a beginner, this will be enough to help you understand the concept, but definitely not enough for investing in stocks.
Calculation
We can calculate free cash flows as: Cash from operating activities - Capital Expenditures.
FCF = CFO - CapEx
From the above example, we compute FCF as:
$ 17,665
- $ 10,491
= $ 7,174
We use free cash flows to understand how much money is left for investors after most obligations have been met. This is similar to the amount of cash people are left with on their bank account after expenses.
Free Cash Flows vs. Profit
Free cash flows are similar to profit3 but attempt to approximate what a company gets in the bank, rather than what is considered as profit in the accountant’s book.
Practical Example
In order to understand the difference between profit and FCF just think of what you bring to the bank vs. what you make from assets that are not cash.
The most common non-cash items are D&A (depreciation & amortization) and SBC (stock based compensation).
In calculating profit, you subtract D&A as an expense, but when looking at the cash flows, you add it back because no cash spending4 actually happened.
In the example of SBC, an employer may give workers company stock as part of their compensation. This is recorded as an expense, lowering your net profit. But since stocks are not cash, it gets added back to the cash flows, making them look bigger than profits.
Edspira has a great video on the differences between net income (profit) and cash from operating activities (What we use before subtracting CapEx):
Why is Free Cash Flow Important?
FCF is important for investors. It is arguably a better measure of the company’s ability to produce cash. Ideally, profit and FCF should be the same number, but when they are not, lean towards trusting the cash flows.
Note: Executives have gotten more savvy at presenting the FCF output, and one should trust FCF numbers only if they truly understand them. Unfortunately, this article only explains the basics, which are not what finance professionals should use - ever.
A.k.a. Investors, shareholders.
CFO = Net income + Non-cash items + change in working capital.
A.k.a. Earnings, net income, net profit. It is found in the income statement and represents what a company makes after all expenses are paid.
This is known as accrual accounting and for the purpose of our article we can imagine it as what is written down in the accounting books, as opposed to what is being transacted.