What is free cash flow?
Free cash flow is the cash a business keeps after paying for the assets it needs to keep running: operating cash flow minus capital spending. It is the cash the owners get their hands on — the money left over once the day-to-day work has paid for itself and the machines and computers are paid for.
A positive free cash flow means the business funds itself; a business with a negative free cash flow burns cash and must borrow, raise money, or draw on reserves to keep going. Try the numbers on the free cash flow calculator and it does the subtracting for you.
The free cash flow formula
The formula is free cash flow = operating cash flow − capital expenditures. The operating cash flow is the cash the day-to-day work brings in — customers paying, suppliers and staff paid, before buying long-lived assets. The capital expenditures, or capex, is the money spent on property, plant and equipment — the machines, vehicles, buildings and computers the business runs on. Take the second off the first and you have the free cash flow. The answer is a dollar figure, not a percentage — write it as $350,000.
Step 1: work out the operating cash flow
Start with the cash the day-to-day work brings in. The operating cash flow is the cash from customers, minus the cash paid to suppliers and staff — before buying long-lived assets. Here is the worked example: operating cash flow of $500,000. That is the cash the business made from its day-to-day work, before a dollar went to new assets.
Step 2: work out the capital expenditures
Take the money the business spent on long-lived assets. The capital expenditures are the machines, vehicles, buildings and computers the business runs on — the assets it needs to keep running. Here is the worked example: capital expenditures of $150,000. That is the cash that left the business to pay for its assets.
Step 3: take the capex off the operating cash flow
Take the capital expenditures off the operating cash flow. Here is the worked example: $500,000 − $150,000 = $350,000. So the free cash flow is $350,000 — the business keeps $350,000 of cash after paying for its assets. The free cash flow calculator runs the subtraction for you.
Three worked examples
Example one — the headline numbers. A business has operating cash flow of $500,000 and capital expenditures of $150,000. The free cash flow is $500,000 − $150,000 = $350,000.
Example two — a smaller business. A business has operating cash flow of $120,000 and capital expenditures of $40,000. The free cash flow is $120,000 − $40,000 = $80,000.
Example three — working to a target. A business wants a free cash flow of $400,000 and it already spends $150,000 on capital expenditures. The operating cash flow it needs is $400,000 + $150,000 = $550,000. In other words, the operating cash flow needed for a $400,000 free cash flow is $550,000, and the capital expenditures allowed is $100,000. The free cash flow calculator runs the target check for you.
One reverse to check your answer
Work the numbers backwards. A business wants a free cash flow of $400,000, and it spends $150,000 on capital expenditures. The smallest operating cash flow that reaches the target is $550,000. A dollar less, and the free cash flow falls short of the $400,000 target. The free cash flow calculator runs the reverses for you.
What a $350,000 free cash flow means
A $350,000 free cash flow means the business keeps $350,000 of cash after paying for its assets. It is the cash the business can use to pay down debt, pay dividends, buy back shares, or fund growth without borrowing. It is the cash the owners actually get their hands on. A $350,000 free cash flow in a consultancy and a $350,000 free cash flow in a trucking fleet are different stories, because one runs on thin capex by design and the other cannot avoid it — compare free cash flow within one industry, not across them.
High free cash flow vs low free cash flow
High free cash flow relative to sales means an efficient cash machine — software companies are famous for it, because their capex is small. A low or negative free cash flow is normal for a business in a heavy building phase — a new factory or a fleet renewal depresses one year’s figure. Free cash flow margin is free cash flow divided by revenue — the share of each sales dollar the business keeps after its assets are paid for. Neither high nor low is good or bad on its own — the industry and the year decide what the number means.
Why free cash flow is read year over year
Free cash flow is the starting point for a discounted cash flow valuation: the value of a business is the present value of its future free cash flow. One year of free cash flow says little on its own — a new factory or a fleet renewal depresses one year’s figure, and a quiet year flatters it. Read free cash flow year over year, and the pattern tells you whether the business funds itself or burns cash to keep going.
What negative free cash flow means
Negative free cash flow means the business spends more on its assets than its day-to-day work brings in. Here is the worked example: operating cash flow of $100,000 and capital expenditures of $150,000 give a free cash flow of −$50,000.00. A negative free cash flow means the business spends more on its assets than its day-to-day work brings in — it burns cash and must borrow, raise money, or draw on reserves to keep going — and a negative free cash flow is not a bargain signal, it is a warning sign. The calculator shows the negative figure with a note, never hides it and never shows “—” for it.
The mistakes to avoid
Four mistakes catch almost everyone. First, mixing up free cash flow and profit: profit counts non-cash items like depreciation and ignores when the capex cash actually leaves, so a profitable business can still run out of cash. Second, mixing up free cash flow and operating cash flow: operating cash flow ignores the cost of maintaining the assets, so it flatters an asset-heavy business. Third, reading one year as the whole story: a new factory or a fleet renewal depresses one year’s figure, so read free cash flow year over year. Fourth, treating free cash flow as profit: it says nothing about debt, interest, tax, or the quality of the operating cash flow. Check each one before you trust the number. Read the guide to EBITDA and the guide to operating leverage for the other side of the same accounts.