How it is calculated
Free cash flow is operating cash flow less capital expenditure. Both come from the cash flow statement: operating cash flow is the cash generated by running the business, and capital expenditure — often labelled purchases of property, plant and equipment — is what was spent on long-lived assets.
Companies disagree about the sign of capital expenditure in their structured data, since it is an outflow. WylthIQ always treats it as an amount spent, so a company that records it as a negative number is not mistakenly credited with extra cash.
Why it differs from profit
Net income includes items that are not cash, and misses cash that is not income. Depreciation reduces profit without any cash leaving; money tied up in unpaid invoices or unsold inventory reduces cash without touching profit; spending on a factory reduces cash at once but reaches profit only gradually, through depreciation.
Over a long run the two should broadly agree. A company whose profit consistently exceeds its free cash flow merits a closer look at what is absorbing the cash.
What it is used for
Free cash flow sits behind several of the most useful comparisons between companies.
- Free cash flow margin — free cash flow divided by revenue — shows how much of each sale becomes spare cash.
- Price to free cash flow — market value divided by free cash flow — sets the share price against that cash, and is harder to flatter than price to earnings.
- Dividend cover: comparing dividends paid with free cash flow shows whether a dividend is funded by the business or by borrowing.
Where it misleads
Capital spending is lumpy. A company building a new plant can show negative free cash flow for a year or two while it invests in growth, and a company cutting investment can flatter its free cash flow while storing up problems for later.
Stock-based compensation is added back in operating cash flow because no cash changes hands, yet it dilutes existing shareholders. For companies that pay heavily in shares, free cash flow overstates the cash truly available to current owners.
Operating cash flow can also be managed at the edges — by delaying payments to suppliers around the year end, for example — so a single year deserves less weight than the trend across several.
A worked example
Figures invented for illustration
| Operating cash flow | $180m |
|---|---|
| Capital expenditure | $60m |
| Free cash flow | $120m |
| Revenue | $1,000m |
| Free cash flow margin | 12% |
| Market value | $2,400m |
| Price to free cash flow | 20x |
Free cash flow is $180m less $60m. The margin divides it by revenue of $1,000m, and price to free cash flow divides the market value of $2,400m by it.