Free Cash Flow

Starter — for Never bought a share

Free cash flow is the money left over after a business has paid for everything it needs to keep running — the cash an owner could actually take out.

Where it comes from

Every public company publishes a cash flow statement. Two lines matter here. "Cash from operating activities" is the cash the business generated from trading. "Capital expenditure" is what it spent on buildings, machines and equipment. Subtract the second from the first and you have free cash flow.

Why not just use profit?

Profit is an accounting figure: it counts a sale when it is made, not when the customer pays. Cash flow counts when money arrives. A company can report a good profit and still run out of cash, which is why free cash flow is the figure that answers "did this business produce money?" rather than "did its books show a gain?"

The simple test

If a company consistently produces free cash flow, it can pay dividends, buy back shares, pay down debt or invest in growth without borrowing. If it consistently does not, it must be financed by someone else — lenders or new shareholders — and that is a different, riskier kind of company.

What to take away

• FCF = cash from operations − capital spending.
• It is the cash an owner could take out without shrinking the business.
• Profit can look good while cash runs out; FCF is the reality check.

Medium — for Invested before, reads the news

Free cash flow converts reported profit back into money, then subtracts the investment needed to keep the business running — it is the closest thing the statements have to owner earnings.

Building it from the statement

Start at operating cash flow. It already reverses non-cash charges (depreciation, amortization, impairments, stock-based compensation) and adjusts for working capital, so it is profit with the accounting undone. Then subtract capital expenditure, which you find in the investing section. The result is cash available for debt repayment, dividends, buybacks and acquisitions.

Maintenance capex versus growth capex

Not all capex is equal. Maintenance capex keeps current capacity alive; growth capex adds new capacity. Only maintenance capex is genuinely required, so a business that reports $45m of FCF after $145m of capex — most of it expansion — is healthier than one reporting the same $45m after $145m of barely-sufficient replacement. Companies do not split the two for you, so the honest approximation is to compare capex with depreciation over several years: persistently higher capex than depreciation means real growth investment.

FCF margin and FCF conversion

Two ratios make FCF comparable. FCF margin is free cash flow divided by revenue — how many cents of each sales dollar survive to the owner. FCF conversion is free cash flow divided by net income — the share of reported profit that arrived as cash. A conversion ratio consistently below 80–90% over years means reported earnings are running ahead of cash, which is where accrual problems show up first.

What moves it, and what does not repeat

FCF is volatile because three of its drivers are volatile: working capital swings (a customer pays late, or inventory is built ahead of a launch), the timing of large projects, and one-off payments such as tax settlements or litigation. Read a three-to-five-year average, and read the cash flow statement next to the balance sheet change in working capital lines, before drawing a conclusion from any single year.

What to take away

• FCF = operating cash flow − capex, both from the cash flow statement.
• Maintenance capex is required; growth capex is optional — depreciation is a rough yardstick for the split.
• FCF margin makes companies comparable; FCF conversion exposes earnings that are not turning into cash.
• Use a multi-year average: working capital and project timing make single years noisy.

High — for Works with this number already

FCF is a construct too: the analyst chooses where to draw the line between operating and investing, and every choice — leases, capitalized software, R&D, SBC — changes the number without changing the business.

The line is a choice

There is no single "free cash flow" in GAAP. Anything a company capitalises (software development, content, exploration, borrowing costs) moves cash out of operating flow and into capex, or the reverse. Items inside operating cash flow — SBC add-back, the working capital delta, deferred revenue changes — can dominate. A disciplined FCF figure states its definition and applies it consistently across the peer set and across time; an undisciplined one is a number chosen to support a conclusion.

Stock-based compensation: the case that matters most

SBC is added back in operating cash flow because no cash leaves. But dilution is a real transfer of value from existing owners, and in software it routinely exceeds 2% of shares a year. The legitimate treatments are: subtract the economic cost (some use the expense less the change in share count), or model the dilution. Adding it back and then ignoring dilution double-counts the benefit — the most common overstatement of FCF in the growth universe.

Leases, maintenance capex and the pseudo-FCF

Under current lease accounting, operating lease payments largely sit in financing, so operating cash flow flatters businesses with heavy leased footprints (retail, restaurants, airlines). For those, deduct lease payments from FCF. Similarly, "adjusted FCF" that adds back restructuring and integration costs every year is not free cash flow; it is cash flow plus a recurring expense the company would rather you ignore.

Linking FCF to value, not to a number

Free cash flow is an input to value, not value itself. A discounted cash flow needs FCF projected over a horizon plus a terminal value, discounted at a cost of capital that reflects the risk of those flows. Which is why a company with negative current FCF and a large growth capex programme can be worth more than a high-FCF business with no reinvestment runway. The discipline is consistency: the same FCF definition in the projection, the comps and the historical record — otherwise the model is comparing three businesses that have never existed.

The quality questions to ask before believing it

Is conversion above 80% across a cycle? Is receivables growth faster than revenue growth? Is inventory building while sales slow? Are the add-backs recurring? Does capex exceed depreciation, and is the excess earning a return? Does FCF fund the dividend and buyback, or is the payout funded by debt? Every one of these is answerable from the statements, and the answers are what separate a cash machine from a company reporting one.

What to take away

• FCF has no single GAAP definition — state yours and keep it constant across comps and time.
• Adding SBC back and ignoring dilution is the most common FCF overstatement.
• Deduct lease payments for lease-heavy businesses and treat recurring "one-off" costs as costs.
• FCF is an input to value: consistent with the projection, the discount rate and the capex assumptions.
• Conversion, receivables-versus-revenue growth and capex-versus-depreciation are the fastest quality checks.