Julian Shocron: What Free Cash Flow Is and How to Calculate It
Julian Shocron explains free cash flow in this note: the money a business genuinely has left once it has paid to run itself and to keep its equipment going.
What is free cash flow, in one sentence?
Free cash flow is the cash a business generates after covering its operations and the investment it needs to keep working.
That leftover is what can go towards paying down debt, rewarding the owners or building a cushion for harder times.
Why isn't profit enough?
Accounting profit mixes in items that are not cash at all:
- Sales that have been booked but not yet collected. The customer owes the money; the bank account has not seen it.
- Expenses that never leave the till, such as depreciation, which spreads the cost of an asset over its useful life.
- Large purchases paid in full today but recorded on the books gradually over several years.
Free cash flow cuts through all three and follows only the money that actually comes in and goes out.
How do you calculate it?
The standard formula is short:
Free cash flow = operating cash flow − capital expenditure (capex)
- Operating cash flow: the cash produced by day-to-day activity, already adjusted for amounts still to be collected or paid.
- Capex: spending on machinery, premises, equipment or software, whether to maintain the business or to grow it.
When operating cash flow is not reported, you can rebuild free cash flow starting from net income:
net income + depreciation and amortization − increase in working capital − capex
What does it look like in a worked example?
Back to the fictional bakery used throughout these notes. All figures are invented and serve only as an illustration.
| Line | Amount |
|---|---|
| Net income | 100 |
| + Depreciation and amortization | 20 |
| − Increase in money owed by customers | 25 |
| − New oven (capex) | 60 |
| Free cash flow | 35 |
The check: 100 + 20 − 25 − 60 = 35.
The bakery reports EBITDA of 170 and net income of 100, yet only 35 of cash is free at the end of the year. The gap comes from two places: the new oven, paid for in full now, and the 25 that customers still owe.
How should you read the result?
- Positive and steady over time: the business pays its own way.
- Negative for a single year: it may reflect a one-off investment, like the oven. The question is what the money was spent on.
- Negative year after year: the business depends on outside money, from lenders or owners, to keep going.
How does it relate to EBITDA and valuation?
EBITDA shows what the core operation earns once interest, tax and accounting wear are set aside; free cash flow shows what is left in the bank after investing. Reading both together tells you far more than either one alone. Free cash flow is also the raw material of a discounted cash flow (DCF) valuation, which Julian Shocron covers in a separate note.
The takeaway
Free cash flow measures the cash that remains after a business has operated and invested. A company can show a healthy profit and still generate little free cash, which is why the two figures are worth reading side by side.
Educational note by Julian Shocron. Not investment advice.
More notes by Julian Shocron: julianshocron.com/en