Free cash flow

Free cash flow is the cash a business generates from its operations after paying for the capital expenditure needed to maintain and grow its asset base. It is the cash available to pay down debt, buy back shares, pay dividends, or reinvest, not just the accounting profit reported on the income statement.

The formula is:

Because operating cash flow already strips out non-cash charges like depreciation and amortisation, and capital expenditure is subtracted directly rather than spread out over years, free cash flow avoids much of the accounting judgment embedded in net income. This is why many investors treat it as a more reliable measure of what a business is worth than reported earnings.

A company can report growing net income while free cash flow shrinks, if rising capital expenditure or deteriorating working capital is consuming more cash than the income statement shows. The reverse is also possible: a company with modest net income but low capital needs can generate substantial free cash flow. Comparing the two over several years is one of the clearest ways to judge earnings quality.

Free cash flow is the base figure behind free cash flow margin and free cash flow yield, and is also commonly used as the input for discounted cash flow valuation models, since it represents cash an owner could take out of the business without impairing its future operations.