What Is Free Cash Flow? Definition, Examples & FAQ
Investors often review a company's free cash flow before deciding whether to buy a stake.
What Is Free Cash Flow?
Free cash flow is cash that is generated by a company's operations after certain cash costs—such as reinvestment in its operations through buildings and/or equipment—have been deducted, but before making any payment to bond or stockholders.
It is an important measure of the value of a company, and investors often turn first to free cash flow when they conduct due diligence during the investment decision-making process. For example, private equity investors are fixated on the amount of cash a company generates, followed by the amount of debt it holds. A company involved in manufacturing may not engage directly in making their products because they use contract manufacturers. It doesn’t need to invest heavily in buildings (i.e., manufacturing plants or warehouses) and equipment, so it ends up with lower capital costs.
Cash is typically generated from three areas: operations (such as revenue from goods or services), investing (providing loans), and financing (sale of stocks or bonds). Items that make up the calculation in free cash flow differ from company to company depending on the industry, and their formulas may not always be simple.
Free cash flow, though, is not a generally accepted accounting principles (GAAP) measurement, and the Securities and Exchange Commission advises that “non-GAAP measures should be evaluated with, and are not a substitute for, GAAP financial measures.” For publicly traded companies, items used in the calculation of free cash flow can be found in the balance sheet and income statement sections of the financial statement filed quarterly and annually with the SEC.
What Are the Uses of Free Cash Flow?
Many companies pass on some of their cash to shareholders in the form of dividends. Publicly traded companies can also use their earnings to repurchase stock in the open market on the premise that reducing the number of outstanding shares will increase earnings per share.
Cash management is an important tool, and utilizing or preserving cash differs by industry and the company’s growth. A company that is a startup or is undergoing expansion because it is in a growth phase, either organically or via acquisition, may quickly go through all of its cash.
In the formative years of Tesla (Nasdaq: TSLA), the carmaker used the cash it had on hand to invest heavily in new factories and equipment to produce as many electric vehicles as it could each year. Tesla went public in 2010 but didn’t become free-cash-flow positive until 2019.
In the case of Apple (Nasdaq: AAPL), the company saved a lot of its cash from selling its popular iPods in the early 2000s, a lesson it learned after almost going bankrupt in the late 1990s. Also, Apple outsourced the production of iPods and other devices to contract manufacturers, reducing the need to spend heavily on constructing new plants and purchasing equipment. Apple’s large cash pile, which started to exceed $100 billion, attracted activist investors who called for the company to pay dividends and buy back stock.
When investors seek to invest in a company, one important measure is the amount of money it generates in specific, regular periods.
How to Calculate Free Cash Flow (Example: Tesla)
The basic formula for free cash flow is cash from operations minus capital expenditures. Each company has its own method of presenting its financial statement, and capital expenditures don’t always show up as an item. That must then be calculated from other items on a company’s balance sheet and income statement. For example, Tesla's capital expenditures, as shown in the table below, are mentioned outright in its Form 10-K, but are also listed separately as a line item, "Purchases of property and equipment excluding finance leases, net of sales", under cash flows from investing activities.
Free Cash Flow Formula
Basic Formula
Free Cash Flow = Cash From Operations – Capital Expenditures
| Tesla's Free Cash Flow (in millions of dollars) | 2020 | 2019 | 2018 |
|---|---|---|---|
Cash From Operations | 5,943 | 2,405 | 2,098 |
- Capital Expenditures | 3,157 | 1,327 | 2,101 |
_______________________________ | _______________ | _______________ | _______________ |
Free Cash Flow | 2,786 | 1,078 | -3 |
Formula With Dividends
Free Cash Flow = Cash From Operations – Capital Expenditures – Dividends Paid
The SEC, while not acknowledging free cash flow as a GAAP measure, includes dividends as part of the formula. The SEC, however, says that ‘net cash provided by operating activities,” a line item that appears in the balance sheet, is the most directly comparable GAAP financial measure found in a company’s financial statement.
Cash From Operations Breakdown
Free Cash Flow = Net Income + Non-Cash Expenses – Increase in Working Capital – Capital Expenditures
An elaborate formula involves breaking down cash from operations into three parts: net income, non-cash expenses, and increase in working capital. Net income is a company’s earnings after all expenses have been paid from revenue, and non-cash expenses include expenses that aren’t paid in cash such as costs for intangible assets. (Depreciation and amortization are examples of non-cash expenses.) Increase in working capital can be calculated by subtracting total liabilities from total assets, and that difference represents the capital used in a company’s normal operations.
Frequently Asked Questions (FAQs)
The following are answers to some of the most common questions investors ask about free cash flow.
How Does Free Cash Flow Differ From Net Income?
Net income can be used in the calculation of free cash flow.
What Is the Free Cash Flow Hypothesis?
When a company has too much cash on hand, executives tend to make poor investment decisions, and they spend impulsively—only to end up in ventures or projects that become unprofitable. That’s in contrast to a company being highly leveraged, which pushes management to be frugal and diligent about its finances and investment decisions.
Is Free Cash Flow the Same as EBITDA?
EBITDA (earnings before interest, tax, depreciation, and amortization) is a measurement of income and is different from free cash flow. For example, EBITDA doesn’t account for capital expenditures, which free cash flow does.
What Is Discounted Free Cash Flow?
Discounted free cash flow is a company’s enterprise value plus future cash flows over a specific period in time, discounted by its weighted average cost of capital, which is the average cost across equity, debt, and preferred shares.
Is Free Cash Flow Cumulative?
Yes, cash that is leftover from the previous accounting period is combined with the net cash position of the latest period.
Can Free Cash Flow Go Negative?
Free cash flow can be negative if the company is spending more than the capital it can raise through equity or bond sales, or if it burns through all of the cash it generates.