Free Cash Flow: How to Measure the Cash a Business Actually Generates
A company can report strong net income and still run out of cash. Net income includes non-cash charges like depreciation and ignores cash spent on equipment and working capital. Free cash flow (FCF) adjusts for both, giving you the cash the business actually produced.
Key takeaway: Net income tells you what a company earned on paper. Free cash flow tells you how much cash it generated.
Why Net Income Is Not Enough
Net income follows accrual accounting rules. Revenue is recorded when earned, not when collected. Expenses are recorded when incurred, not when paid. And large capital purchases are spread across years as depreciation rather than recognized when the cash goes out the door.
Consider a company that reports $200,000 in net income. Sounds profitable. But during the same year it spent $300,000 on new equipment and its customers owe it $150,000 that has not been collected yet. The company's bank account tells a different story than its income statement.
Free cash flow starts with operating cash flows and subtracts capital expenditures, so you see what actually hit the bank account.
The FCF Formula
The formula for free cash flow to the firm (FCFF) is:
FCF = EBIT x (1 - Tax Rate) + Depreciation - Capital Expenditures - Change in Working Capital
- EBIT: Earnings before interest and taxes (operating income).
- Tax Rate: The corporate tax rate applied to operating income.
- Depreciation: A non-cash expense that reduces reported income but does not use cash. Adding it back reflects the actual cash position.
- Capital Expenditures (CapEx): Cash spent on property, equipment, and other long-term assets.
- Change in Working Capital: The change in current assets minus current liabilities. An increase in working capital uses cash; a decrease frees cash.
Why EBIT instead of net income? FCF to the firm measures cash available to all capital providers, both debt holders and equity holders, before interest payments. This is the version you plug into DCF valuation models and discount at WACC.
The Financial Statements
Here are simplified financials for a mid-size manufacturer.
Income Statement:
| Amount | |
|---|---|
| Revenue | $5,000,000 |
| Cost of Goods Sold | $3,000,000 |
| Gross Profit | $2,000,000 |
| Depreciation | $200,000 |
| Other Operating Expenses | $1,000,000 |
| EBIT | $800,000 |
| Interest Expense | $100,000 |
| Pretax Income | $700,000 |
| Taxes (25%) | $175,000 |
| Net Income | $525,000 |
Balance Sheet (Selected Items):
| This Year | Last Year | Change | |
|---|---|---|---|
| Accounts Receivable | $400,000 | $350,000 | +$50,000 |
| Inventory | $600,000 | $500,000 | +$100,000 |
| Accounts Payable | $300,000 | $250,000 | +$50,000 |
Additional Information:
| Amount | |
|---|---|
| Capital Expenditures | $350,000 |
| Depreciation | $200,000 |
| Tax Rate | 25% |
Calculating Free Cash Flow
Step 1: After-tax operating income.
EBIT x (1 - Tax Rate) = $800,000 x 0.75 = $600,000
This is sometimes called NOPAT (net operating profit after taxes). It is the operating profit after taxes but before interest.
Step 2: Add back depreciation.
$600,000 + $200,000 = $800,000
Depreciation reduced EBIT but no cash left the building. Adding it back recovers the actual cash from operations.
Step 3: Subtract capital expenditures.
$800,000 - $350,000 = $450,000
The company spent $350,000 on new equipment. That outflow never shows up on the income statement (only the depreciation of past purchases does), but the cash is gone all the same.
Step 4: Subtract the change in working capital.
Working capital changes show how much cash got tied up in day-to-day operations.
| Item | Change | Cash Effect |
|---|---|---|
| Accounts Receivable | +$50,000 | Uses cash (customers owe more) |
| Inventory | +$100,000 | Uses cash (more stock on hand) |
| Accounts Payable | +$50,000 | Frees cash (paying suppliers later) |
| Net Change in Working Capital | +$100,000 |
Receivables and inventory went up by $150,000 (cash tied up), while payables went up by $50,000 (cash preserved). The net change is +$100,000, meaning the company used $100,000 more in working capital this year.
$450,000 - $100,000 = $350,000
Free cash flow is $350,000.
The Full Calculation
Putting it all together:
FCF = EBIT x (1 - T) + Depreciation - CapEx - Change in Working Capital
FCF = $800,000 x 0.75 + $200,000 - $350,000 - $100,000
FCF = $600,000 + $200,000 - $350,000 - $100,000
FCF = $350,000
The company reported $525,000 in net income but generated only $350,000 in free cash flow. The gap comes from capital spending exceeding depreciation by $150,000 and working capital absorbing another $100,000, partially offset by the fact that FCF excludes interest expense (which net income includes).
FCF vs Net Income
| Net Income | Free Cash Flow | |
|---|---|---|
| Basis | Accrual accounting | Cash accounting |
| Depreciation | Subtracted as an expense | Added back (non-cash) |
| Capital expenditures | Not included (only depreciation of past CapEx) | Subtracted in full |
| Working capital changes | Not directly visible | Subtracted when capital is tied up |
| Interest | Subtracted | Not subtracted (FCF to the firm) |
| Use | Profitability reporting | Valuation, capital allocation |
A company can grow net income by deferring equipment replacements or letting receivables pile up. FCF catches both. That is why analysts and investors focus on FCF when the two numbers diverge.
Why Free Cash Flow Matters
FCF is the number behind most corporate finance decisions:
- DCF valuation: Enterprise value is the present value of all future free cash flows, discounted at WACC.
- Dividend capacity: A company can only sustain dividends from cash, not accounting profits.
- Debt repayment: Lenders look at FCF to judge whether the company generates enough cash to cover its obligations.
- Capital allocation: Management uses FCF to choose between reinvesting, paying down debt, buying back shares, or paying dividends.
Conclusion
Free cash flow tells you how much cash a business actually produced, not how much profit it reported. Start with after-tax operating income, add back depreciation, subtract CapEx, and adjust for working capital. When net income and FCF tell different stories, trust the cash.
For the discount rate used to value future free cash flows, see our guide on WACC. For how DCF output connects to equity value, see our guide on enterprise value. For the valuation framework that uses FCF as its input, see our guide on NPV and IRR. For the financial statements that feed into this calculation, see our guide on financial ratios.
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