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Free Cash Flow (FCF)

This week we take a look at Free Cash Flow and how we can use it within a financial analysis setting.

What is Free Cash Flow?

The Free Cash Flow (FCF) represents the cash generated, after cash outflows to support the operating activities of the business and to maintain its capital assets. It’s a measure of profitability, which excludes the non-cash expenses in the Income Statement.

Some investors prefer FCF over earnings as a measure of profitability, because it excludes interest payments and generally considers cash items only. However, as FCF accounts for investments in capital assets, it may have an unsteady trend over the years.

The FCF also considers changes in the Working Capital, which can provide essential insights into the financial health of the company. Having a profitability measure that includes Working Capital gives us information not found in the Income Statement. We can draw valuable conclusions from this:

  • A decrease in the balance of Accounts Payable might mean the company is getting worse payment terms and credit from suppliers;
  • At the same time increase in the balance of Accounts Receivable may be an indication that the company is struggling with collection from clients;
  • An increase in inventory balances might be due to the company stock-piling more products than it can sell, or it can also mean the company is performing worse than expected saleswise.

Free Cash Flow is not subject to any disclosure requirements, but it can be a great double-check on the reported profitability of a company. 

It’s tough to say how much FCF should be, so it is better to analyze its trend over time, instead of looking at actual values for a period. For analysts, it’s common to look at the stability of the FCF trend as a measure of risk. Stable trends generally mean share price drops are less likely for the business. On the other hand, falling trends and trends differing a lot from sales and earnings trends, indicate a higher likelihood of poor share price performance for the company.

Calculating Free Cash Flow

FCF is most easily derived from the Cash Flow Statement:

If we do not have access to the Cash Flow Statement, we can calculate FCF from the Income Statement and Balance Sheet, which are usually easier to get a hold of.

The formula then becomes:

We get to this extended formula by looking at the Cash Flow Statement structure. Cash from Operations is derived from Net Income, adjusted with add-backs for the Non-cash expenses, and adjusted with the change in non-cash Working Capital (Accounts Payable, Inventory, Accounts Receivable). This way, we can change the Cash from Operations (CFO) based on the following formula:

We can then look further into Non-cash expenses. These represent the sum of Income Statement elements that are not cash-related (e.g., depreciation & amortization). Usually, we can include the following as non-cash expenses:

  • Depreciation & amortization;
  • Stock-based compensations;
  • Impairment charges;
  • Gains/Losses on investments.

Next, we look at Changes in Non-cash Net Working Capital. This is usually the most complex part, especially in companies with complex Balance Sheets.

In a simple Balance Sheet, the impact will come from Accounts Payable (AP), Accounts Receivable (AR) and Inventory (INV). Then the changes can be calculated by subtracting the opening balances (OB) from the closing balances (CB):

CAPEX is also a measure we can calculate from the Balance Sheet and Income Statement if we do not have the Cash Flow Statement:

Using the above, we get the FCF formula:

Applications of Free Cash Flow

The Free Cash Flow can be a useful measure of profitability, as it is harder to manipulate and tells a better story than other more commonly used metrics. The Income Statement spreads invested cash over more prolonged periods via depreciation and amortization, to smooth out business performance over more extended periods. The FCF shows us the here and now. It has a volatile nature, so it’s best to observe it over a few years.

Companies that don’t have to make a lot of long-term investments have more steady FCF, closer to Net Income. On the other hand, companies that have to invest in manufacturing assets have much more volatile FCF. Mature companies usually have much steadier FCF trends, as they are no longer making huge investments in capital assets.

Valuators often substitute earnings with FCF when valuing mature businesses or capital-light businesses (less long-term investments made). The Free Cash Flow is especially crucial for stakeholders that are more interested in liquidity than profitability. 

Most commonly, analysts look in two variations of FCF:

FCFF – Free Cash Flow to the Firm

This variant of FCF shows the ability of the business to generate cash and is calculated with the formulas we discussed above;

FCFE – Free Cash Flow to Equity

This metric shows the cash flow available to the equity shareholders. It is also known as levered cash flow and shows how much dividends can be distributed to shareholders after all expenses are covered.

We can calculate FCFE with the following formula:

It is important to notice that we are using the change in Net Borrowings here, not the balance. This makes sense when using the Cash Flow Statement for FCFE calculation, but is not always made clear in literature.

FCF is essential, as it is needed to boost the growth of the company. However, while more FCF can help a business grow, the lack of FCF doesn’t always mean the company is struggling. A low FCF can also mean that the firm invested heavily and will have future benefits and growth from the acquired capital assets.

Analysts are usually focused on the operating performance of the company, which makes a valuable metric out of the cash flow based FCF. It is common for analysts to employ FCF in Discounted Cash Flows analysis and use it instead of Earnings for mature or capital-light companies, replacing price-to-earnings ratios with price-to-FCF ratios:

We can also calculate the Price to FCF via the market capitalization of the company:

Another metric that we can calculate with FCF instead of Earnings is the Earnings Yield. Analysts often prefer to look at FCF Yield, when evaluating the return of stocks in mature companies. The FCF Yield determines the free cash flow per share the company is expected to make against its market price per share – the higher the FCF Yield is, the better. We calculate it as follows:

We must consider additional information about a business when looking into FCF and incorporating it in our analysis. There are some situations where a company will report positive FCF, but this won’t be a sign for good financial health:

  • The company is selling off significant assets;
  • They are cutting back on or delaying capital investments;
  • Payments to suppliers are being delayed;
  • Collection of receivables is expedited with costly early-payment discounts;
  • The company is reducing marketing expenses;
  • Dividends are not paid;
  • The company is entering into sale and lease-back arrangements for critical assets;
  • Management is accepting large advance payments from clients to support short-term operations.


To get a better grasp on the Free Cash Flow, let us take a look in some examples.

To illustrate the FCF calculation, I went and downloaded the 2017 financial statements of OMV Bulgaria, a company in the fuel industry. Using data from the Income statement and Balance sheet of the entity, we can start calculating FCF. Starting from the bottom, we first calculate the changes in Working capital and the non-cash expenses:

Using the two, we can then start with Net Income and calculate Cash from operations:

The next thing we need is to calculate CAPEX, which we do with the abovementioned method to derive it from the Balance sheet and Income statement:

Combining the last two, we can calculate the Free Cash Flow for FY 2017:

Going a bit further, we can calculate the Free Cash Flow to Equity, again using only information from the Balance sheet and Income statement:

We can also look at the analysis metrics we discussed above. From the financial statements of OMV, we see that they have 1,212,063 shares. We have no information on the market capitalization or share price of OMV, so let us assume the company has a market cap of 300 mil euro or 300,000 thousand. We get a share price of 247.51 euro.

We can then go ahead and calculate the Price to FCF ratio:

And we can also look at the FCF Yield:

You can go ahead and take a more detailed look into the calculation in the Excel file at the end of the article.


It the end, the Free Cash Flow is just another metric, it doesn’t tell us everything, but observing the difference between FCF and Net Income will make us better analysts. Thank you for reading and do not forget to download the Excel working file below:

Dobromir Dikov


Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.

In my spare time, I am into skiing, hiking and running. I am also active on Instagram and YouTube, where I try different ways to express my creative side.

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