What is Free Cash Flow (FCF) and how to calculate it?

What is Free Cash Flow

In this post we are going to cover a key term from the world of corporate finance: Free Cash Flow. We will take an in depth look at common and alternative definitions of Free Cash Flow, compare the profit view and the cash flow view of looking at a company’s performance, and we will analyze the Free Cash Flow numbers published by companies like Exxon Mobil, Facebook, General Electric and General Motors. Let’s get started! The first thing to be aware of is that Free Cash Flow is a non-GAAP metric. This means it is not covered by Generally Accepted Accounting Principles, and to a certain extent companies have some creative liberty in defining the term.

Free Cash Flow in the financial statements

Let me give you some context, so you know where Free Cash Flow fits in. There are three financial statements: The balance sheet, an overview of what we own and what we owe at a point in time. The income statement, an overview of the profit or income that you generate during a period. And… The cash flow statement, an overview of how much cash you generate, and where you spend your cash during a period. Free Cash Flow, as its name suggests, is a cash flow metric.

Free Cash Flow definition

If you look through annual reports or finance textbooks looking for a definition of Free Cash Flow, you will often find something along the following lines:

Free Cash Flow is that part of the total cash flow that is not required for operations or reinvestment. Free Cash Flow is the part of cash flow that is available for distribution among all the securities holders (debt or equity) of an organization. In other words, that part of the cash flow you could take out of the company (to pay down debt, or pay a dividend to shareholders) without hurting its ongoing operational capability to pay the bills, and without hurting the investment plan.

Free Cash Flow calculation

To calculate Free Cash Flow, you take the most comparable GAAP metric Cash From Operating Activities (or CFOA) and deduct Capital Expenditures. You can find these numbers in the cash flow statement that a company publishes in its annual report or quarterly earnings release, so you can always calculate Free Cash Flow yourself by looking up those numbers. Some companies explicitly mention and calculate Free Cash Flow for you. About half of the annual reports that I reviewed in preparing for this video had companies publishing their version of Free Cash Flow.

Unfortunately, the definitions that companies use are not always the same. Fortunately, you have come to the right place, the Finance Storyteller channel, to learn how to make sense of this. If you look up Free Cash Flow in an annual report, you will see that companies provide you with some context to their definition, and disclaimers as to what you should be aware of when analyzing Free Cash Flow numbers.

The following sentences are part of Facebook’s annual report discussion on Free Cash Flow: “we define” and “we have chosen” clearly indicate that this is a non-GAAP metric that is not part of Generally Accepted Accounting Principles, but something that a company can choose to define in a certain way. The last sentence shown here, about other companies possibly presenting similarly titled measures differently is part of a well-worded paragraph starting with the words “Free Cash Flow has limitations as an analytical tool, and you should not consider it in isolation or as a substitute for analysis of other GAAP financial measures”. I encourage you to look up the full text in the latest Facebook annual report.

Free Cash Flow example

It’s time to dive into the numbers and review Facebook’s Free Cash Flow over the past couple of years. Like many other companies, Facebook puts the older years on the right, and the latest years on the left. If you go from 2011 on the right to 2015 on the left, you see the net cash provided by operating activities growing very quickly, especially in the 2013 to 2015 timeframe.

The cash outflow for property and equipment also goes up significantly, especially in 2014 and 2015, as Facebook expands its capacity. 2015 has been a record year in Free Cash Flow for Facebook: 6.1 billion dollar! At the moment of putting together this video, I only have Facebook’s numbers for the first three quarters of 2016, but those 9 months are already higher on each of the line items than the 12 months of 2015, so Facebook should have another record Free Cash Flow year in 2016.

Later on in this post, we will look at the Free Cash Flow of companies in very different industries: General Motors, Exxon Mobil and General Electric.

Profit vs Free Cash Flow

So does a company that is very profitable always have a very high Free Cash Flow? That’s not necessarily the case. The reason for that is that the way you measure profitability is different from the way you measure cash flow. In the profit view of a company, the matching principle is very important: matching the revenue and expenses to the period in which they occur. In the cash flow view of a company, the moment when cash is flowing in, and cash is flowing out of the company is key.

Let me illustrate this with some transactions. Let’s assume we run a small factory that produces widgets. If we purchase raw material and pay the supplier for it, we book a debit to inventory and a credit to cash. This transaction does not impact profitability, but it does impact cash flow. If you use the machines in the factory to produce, you book a depreciation charge in the income statement. For cash flow, depreciation is not relevant, as you do not pay depreciation to anyone, hence there is no cash outflow.

If you want more explanation on how depreciation works and how it is calculated, watch the Finance Storyteller video on depreciation. If you sell goods to a customer on credit, you book the revenue and cost of goods sold of that sale when the goods are delivered and you meet all the revenue recognition criteria. The difference between the revenue and the cost of goods sold is your margin.

For cash flow, this transaction does not do anything, as no cash is coming in to the company yet until the customer actually pays you. If you sell goods to a customer with a cash payment, both profit and CFOA are impacted. It’s only a small step from CFOA to Free Cash Flow: deduct the part of the cash flow that needs to stay in the company to fund new investments or replacements of existing machines (this is called CapEx or Capital Expenditures).

Free Cash Flow comparison between companies

It’s time to start comparing some companies on their Free Cash Flow performance. Don’t jump to conclusions that a company is doing well when their Free Cash Flow is high, they could get there by taking short term measures like limiting their CapEx spending, which puts their longer term financial health at risk. Analyze the numbers, see the context, and only then draw conclusions. Here’s the Free Cash Flow picture for car company General Motors.

Operating Cash Flow in 2015 is slightly higher than that of Facebook, but due to the capital intensive nature of the car industry, CapEx is way higher, and therefore Free Cash Flow is far lower for GM than it is for Facebook. Now let’s look at one company that is a descendant of a corporation started in 1870, and another one that was founded in 1892: Exxon Mobil and General Electric.

Both companies are large multinationals that in recent years have gone through large transformations of their business portfolio. The Free Cash Flow definitions that they use reflect those strategic paths! Once again, words create worlds: the words used in defining strategy impact the world of financial metrics.

If you look at the Free Cash Flow definition of Exxon Mobil, you see that they start off, like everyone else, with a line called Net Cash provided by Operating Activities. Even though this is significantly lower in 2015 than in 2014, in absolute terms it is still very big at 30 billion dollar. Additions to property, plant and equipment are usually between 30 and 35 billion per year, but were cut to 26 billion in 2015.

The next line is one that we have not seen before in the definitions used by other companies: proceeds from sales of subsidiaries, property, plant and equipment, and sales and returns of investments. This is a line that consistently reflects a cash inflow for the past five years, but should be treated with caution as you cannot keep selling parts of your business portfolio forever. You would end up with no company assets at all. Another unusual part of Exxon Mobil’s definition of Free Cash Flow versus that of other companies is the line of additional investments and advances, and the one below of collection of advances.

Over time, these seem to largely offset each other. If you look at the Free Cash Flow numbers per Exxon Mobil’s definition at the bottom, you see how dramatically the picture has changed from the 2011-2012 timeframe of having more than 30 billion in Free Cash Flow per year, to about 20% of that level in 2015 at 6.5 billion dollar. That’s the difference between oil being at $100 per barrel versus $30. Last example is General Electric. Their Free Cash Flow has gone up in recent years.

Just like Exxon Mobil, in their definition GE has chosen to add cash inflows from selling property, plant and equipment, as well as cash inflows from business dispositions. For GE, the “bottom line” in terms of Free Cash Flow is the total of Free Cash Flow plus dispositions.

Free Cash Flow and valuation

It’s time to zoom out from definitions and numerical examples to the big question: why is Free Cash Flow such a big deal in the first place? Well, the reason for that is that Free Cash Flow is a key variable for analysts and investors that try to estimate the value of a firm.

The value of a company today can be seen as the cash that they currently have plus the estimates of future Free Cash Flows discounted back (using the Weighted Average Cost of Capital) to their present value. At the time of writing and producing this video, the market capitalization of Facebook is bigger than that of Exxon Mobil or General Electric.

A very large part of that is driven by the large potential for growth in Free Cash Flow for Facebook. A lot of assumptions go into the valuation calculation, as estimating the future Free Cash Flow of a company requires you not only to have an understanding of its historical performance, but also of its vision, mission and strategy going forward, its competitive landscape, and the impact of all of these on the Free Cash Flow estimates. The further out into the future you go, the tougher it becomes to make a solid estimate. Not an easy task, and possibly an impossible one, in a world that is volatile, uncertain, complex and ambiguous.

Free Cash Flow summary

In summary: Free Cash Flow is a useful non-GAAP metric to look at the performance of a company, but beware of the variation in definitions that exists! Free Cash Flow does not come for free, as in dollar bills just dropping from the air. Companies have to work very hard to generate Free Cash Flow. The best way to think of it is as cash flow that wants to have freedom.

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