The formula, and where the lines are
Free cash flow = net cash provided by operating activities − capital expenditure
Open the cash flow statement. The first subtotal, usually labelled "net cash provided by operating activities", is cash from operations: profit converted into cash after working-capital movements and non-cash charges. In the investing section, the line labelled "purchases of property and equipment" or "capital expenditures" is capex. Subtract the second from the first. For Harbor Foods, the fictional company used across these guides, operating cash flow was $160 million and capital spending $60 million, so free cash flow was $100 million. That is the figure the free cash flow yield article divides by the market value, and the figure the DCF model example grows and discounts.
Worked reconciliation: from net income to free cash flow (illustrative)
The operating section of the cash flow statement starts from net income and shows every adjustment on the way to cash. Reading it tells you why cash differs from profit:
| Line | Harbor Foods, $m | What it means |
|---|---|---|
| Net income | 120 | Accounting profit after interest and tax |
| + Depreciation and amortisation | 55 | Non-cash charges for past investment |
| + Stock-based compensation | 10 | Non-cash pay; a real cost to shareholders |
| − Increase in working capital | −25 | Cash tied up in receivables and inventory, net of payables |
| = Cash from operations | 160 | |
| − Capital expenditure | −60 | Cash spent on property, plant and equipment |
| = Free cash flow | 100 |
Harbor's cash exceeds its profit because depreciation is a charge for spending that happened years ago, and the working-capital build is the part of this year's profit still sitting in customers' hands. In a growing business working capital usually absorbs cash; in a shrinking one it releases cash, which can make a struggling company look briefly rich.
Free cash flow to the firm vs to equity
The simple formula gives a figure after interest, because net income is after interest, and that is free cash flow to equity: what shareholders could receive. A DCF that discounts at a weighted average cost of capital needs the pre-interest version, free cash flow to the firm, also called unlevered free cash flow:
FCFF = EBIT × (1 − tax rate) + depreciation and amortisation − capital expenditure − increase in working capital
FCFE = FCFF − interest × (1 − tax rate) + net borrowing
The difference is the after-tax interest that goes to lenders and the net cash raised or repaid on debt. Discount FCFF at WACC to get an enterprise value and subtract net debt; discount FCFE at the cost of equity to get the equity value directly. The WACC formula article covers the pairing. Mixing them, most often by discounting the after-interest figure at WACC, undervalues any company with debt.
The adjustments that change the answer
- Stock-based compensation. The statement adds it back because no cash left the company. But shares did, diluting every other holder. For a company that pays heavily in stock, subtract it again or treat the diluted share count as the cost; Harbor's $10 million would take free cash flow to $90 million.
- Lease principal. Since lease accounting changed, repayment of lease liabilities appears in the financing section, so rent partly escapes operating cash flow. For retailers, airlines and anyone with many leases, subtract lease principal to get a comparable figure.
- Acquisitions. Buying companies sits in investing cash flow below capex and is excluded from the simple formula. A company that grows by acquisition and reports high free cash flow is reporting the cash before the growth was paid for.
- Capitalised development. Software and some industrial companies capitalise development spending, which moves it from operating expense to investing cash flow. Include it in capex or it vanishes.
- Maintenance vs growth capex. Capital spending to keep the business running is a cost; spending to expand is an investment. Companies rarely split them, but the depreciation charge is a rough floor for maintenance capex, and the gap above it is growth.
- One-offs. Tax refunds, legal settlements and large working-capital releases lift a single year. Use a three-year average for screening.
The quarterly trap
A 10-Q's cash flow statement covers the year to date, not the quarter. The third-quarter filing shows nine months of operating cash flow and nine months of capex. To get the quarter's free cash flow, subtract the figures from the previous quarter's 10-Q. Data services do this inconsistently, and an implausibly large quarterly free cash flow is usually this mistake rather than a great quarter. The how to read a 10-Q article covers the rest of the filing.
Using the number
Free cash flow is the input to three of the most useful valuation tools. Divided by market capitalisation or enterprise value it gives the free cash flow yield, the cash-based cousin of an earnings yield. Grown and discounted it gives a DCF value. And compared with net income over several years it gives cash conversion, a quality measure: a company whose free cash flow persistently trails its profits is reporting earnings it is not collecting. In a stock screen, a free cash flow yield floor paired with a return-on-capital rule, as the what is ROIC article describes, finds cheap businesses that are also good ones. VALYSTR's company pages compute free cash flow from the filed cash flow statement, with the quarterly figures already separated from the year-to-date totals.
Two ratios built from it are worth computing every year. Free cash flow margin, free cash flow divided by revenue, shows how much of each dollar of sales becomes cash the owners could keep; for Harbor, with $1,000 million of revenue, it is 10%. Cash conversion, free cash flow divided by net income, is 100 ÷ 120 = 83% here: a little below one because the business is still investing in working capital as it grows. A conversion rate that falls year after year while profits rise is the earliest sign that the profits are not what they seem.
Screen on free cash flow
Rank thousands of companies on free cash flow yield, cash conversion and return on capital with figures taken from their filings, or describe the screen in words.
Frequently asked questions
What is the free cash flow formula?
Free cash flow = net cash from operating activities minus capital expenditure. Both lines are on the cash flow statement: operating cash flow is the first section's subtotal and capital expenditure is the purchases of property, plant and equipment in the investing section. The longer route starts from net income, adds back non-cash charges, subtracts the increase in working capital, then subtracts capex.
What is the difference between free cash flow and net income?
Net income is accounting profit; free cash flow is the cash actually generated after the investment needed to keep the business running. They differ because of non-cash charges such as depreciation and stock-based pay, because revenue is recognised before cash arrives, and because capital spending is charged to profit gradually but paid in cash at once.
Is free cash flow the same as operating cash flow?
No. Operating cash flow is cash from the business before investment. Free cash flow subtracts capital expenditure, the spending on property, plant and equipment needed to sustain and grow the operations. A capital-intensive company can have strong operating cash flow and little free cash flow.
Should stock-based compensation be subtracted from free cash flow?
Many investors do, because although no cash leaves the company, shares do, and those shares dilute existing holders. The cash flow statement adds it back as a non-cash charge, so free cash flow as reported overstates what accrues to current shareholders at companies that pay heavily in stock. At minimum, look at the figure both ways.
What is the difference between levered and unlevered free cash flow?
Unlevered free cash flow, or free cash flow to the firm, is before interest and belongs to lenders and shareholders together; it is discounted at the weighted average cost of capital to give an enterprise value. Levered free cash flow, or free cash flow to equity, is after interest and net borrowing and belongs to shareholders alone; it is discounted at the cost of equity to give the equity value directly.