How to calculate FCF?
There are three different methods to calculate free cash flow because all companies don’t have the same financial statements. But, here we will present the most common and simplest method. To perform a proper calculation, we need to know operating cash flow and capital expenditures, both obtained from the cash flow statement.
To calculate FCF, find the cash flow from operations (also referred ”net cash from operating activities”) and subtract capital expenditure, which can be found on the balance sheet. The formula for the free cash flow is
FCF = Operating cash flow − Capital expenditures
Operating cash flow is net cash that depends on the company’s operations. It has much better access to real cash earnings than EBITDA or net income. EBITDA does not take into account working capital, i.e. when investors compare the company only with EBITDA, it does not matter whether the company spends 4% of revenue for its own needs or spends 40%. Then the net income does not take into account the capital invested in that period. It can be assumed that this is the depreciation of the purchased assets through the income statement, but this does not include the actual cash used for new business or the purchase of new equipment in a given period. The free cash flow includes the actual capital expenditures Capital expenditures (or CAPEX) represent the amount of money that represents business growth during the period for which we perform analyzes. It includes technology, new equipment, infrastructure.
For example, let us calculate Ann’s cash flow for 2020, according to the company’s statement, if cash flow from operating activities is $1 million and capital expenditures are $550, 500.
FCF = $1, 000, 000 − $550, 000 = $450, 000
FCF can provide valuable insights into a company’s value and the health of its fundamental trends since it accounts for shifts in working capital. A drop in accounts payable (outflow), for example, could indicate that vendors are demanding faster payment. A drop in accounts receiv- able (inflow) could indicate that the business is receiving money from its customers. Assume a company’s net income was $50,000,000 per year for the previous decade. On the surface, that appears stable, but what if FCF has been declining for the past two years due to rising invento- ries (outflow), customers delaying payments (outflow), and vendors requesting faster payments (outflow) from the firm? In this case, FCF will show a serious financial vulnerability that would have been missed if only the income statement had been examined.