How to calculate free cash flow

FCF = cash from operating activities − capital expenditures. Both numbers are on the cash flow statement, one of the three statements explained in fundamental analysis for beginners. Capital expenditures, or capex, usually appear in the investing section as purchases of property and equipment.

The drawing at the top follows a hypothetical company: $230 million of operating cash flow, $80 million of capex, $150 million of free cash flow. FCF is not an official accounting (GAAP) measure, so companies and data sites define it in slightly different ways; when a company reports its own FCF, check what it subtracted. Warren Buffett’s owner earnings is a close cousin that subtracts only maintenance spending; see the Warren Buffett strategy.

Operating cash flow
Cash generated by the business itself over the period: net income adjusted for non-cash items, such as depreciation, and for changes in working capital.
Capital expenditures (capex)
Cash spent on long-lived assets such as equipment, buildings and software, to keep the business running or to grow it.

Why is cash flow different from profit?

Net income follows accounting rules that record revenue when it is earned and spread large costs over time, while cash flow counts money when it actually moves. Three gaps explain most of the difference:

  • Non-cash charges: depreciation reduces profit without spending cash this year, so it is added back to operating cash flow. Stock-based compensation is added back too, as explained below.
  • Working capital: a sale on credit counts as revenue now, but the cash arrives when the customer pays. Rising receivables and inventory absorb cash; paying suppliers later frees it, for a while.
  • Capex: buying a $50 million machine is cash out today, but only a slice of its cost reaches the income statement each year, as depreciation.

Profit up, cash flow down: the biggest red flag

Over several years, healthy companies tend to turn most of their profit into cash. The warning sign is the pattern in the hypothetical drawing below: net income rising every year, from 100 to 190, while operating cash flow falls from 110 to 60. Profits that do not turn into cash may be piling up as unpaid customer bills or unsold inventory, or may come from aggressive accounting.

One year of divergence can have an innocent explanation, such as a big order paid after the year-end. Several years in a row deserve a close look at receivables, inventory and the notes to the accounts. The same check works for earnings per share: EPS growth without cash behind it is weak growth.

Turn your phone sideways to read the drawing. Tap to close.

A hand-drawn line chart over years Y1 to Y5: net income rises in ink from 100 to 190 while operating cash flow falls in red from 110 to 60, the widening gap between them shaded yellow, with a highlighted note reading profit up, cash down: ask why.

FCF margin and FCF yield

Two ratios put FCF in context. FCF margin = FCF ÷ revenue: how many cents of each sales dollar end up as free cash. The hypothetical company has revenue of $1,000 million, so $150 million of FCF is a 15% FCF margin. Compare it with the company’s own history and with its peers, like any margin.

FCF yield = FCF ÷ market cap, or FCF per share ÷ share price. At a market cap of $3 billion, $150 million of FCF is a 5% FCF yield; its inverse, price-to-FCF, is 20. Like the earnings yield in the P/E ratio guide, a higher yield means you pay less for each dollar of cash, as long as that cash keeps coming. Other multiples are covered in valuation ratios.

The stock-based compensation caveat

Many companies, especially in technology, pay employees partly in shares. Stock-based compensation (SBC) costs no cash, so it is added back to operating cash flow, and FCF looks larger than it would if the same people were paid in cash. But the cost is real: new shares dilute existing owners, and many companies spend cash on buybacks just to offset them.

In the hypothetical drawing below, reported FCF is $300 million and SBC is $120 million. Subtract SBC and FCF is $180 million, 40% less. When SBC is large, look at FCF both ways and check whether the share count is rising; diluted EPS shows the same dilution from the earnings side.

Turn your phone sideways to read the drawing. Tap to close.

A hand-drawn three-step bar chart in $ millions: a green reported FCF bar of 300, a red step of −120 for stock-based compensation, and a green FCF after SBC bar of 180, marked −40%; beside it, notes read added back as non-cash, then, highlighted in red, but new shares dilute owners.

Other free cash flow red flags

FCF is harder to dress up than earnings, but it can still mislead. Look for these patterns over several years, not one quarter:

  • Receivables or inventory growing much faster than revenue.
  • FCF boosted by cutting capex below what the business needs: it looks good for a year or two, then the assets age.
  • Cash flow helped by paying suppliers later and later, which cannot go on forever.
  • Dividends or buybacks larger than FCF, paid for with new debt; dividend investing shows how to check dividend coverage.
  • Negative FCF is not always bad: a young company investing heavily in growth can burn cash for years. The questions are whether that spending will earn a return and whether the company has the cash or funding to get there.