Free cash flow, often abbreviated as FCF, is a common measure of a company’s financial performance. It is determined by subtracting capital expenditures from operating cashflow. Specifically, the formula commonly used for FCF is as follows:
Earnings before interest and taxes (1-tax rate) + (depreciation) + (amortization)
– (change in networking capital) – (capital expenditure)
In other words, FCF is the money a company has left over after capital expenditures such as real estate and equipment. The excess cash may be used for opportunities that enhance shareholder value such as expanding production, developing new products, making new acquisitions, paying dividends and reducing debt.
Companies that rely on heavy equipment should be expected to have a more volatile FCF. Image Credit: Mixabest (CC by 3.0)
Some investors and analysts like using FCF as a measure of success because it is generally harder to fake through accounting practices than earnings. However, negative cash flow is not always a bad thing since it can mean that the company is making large investments that could pay off further down the line. Capital light companies, such as Moody’s, will generally have more steady free cash flow since investing in big long-term investments is a minimal part of their business. An example of a company currently expected to make large increases in cash flow is Southwest Airlines.
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