{"id":20322,"date":"2019-04-04T09:00:25","date_gmt":"2019-04-04T14:00:25","guid":{"rendered":"https:\/\/breakingintowallstreet.com\/biws\/kb\/%kb_category%\/free-cash-flow-fcf-tutorial-with-worked-examples-2652\/"},"modified":"2024-08-14T06:46:52","modified_gmt":"2024-08-14T11:46:52","slug":"how-to-calculate-free-cash-flow","status":"publish","type":"biws_kb","link":"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/how-to-calculate-free-cash-flow\/","title":{"rendered":"How to Calculate Free Cash Flow and What It Means (16:37)"},"content":{"rendered":"<div id=\"ez-toc-container\" class=\"ez-toc-v2_0_81 counter-flat ez-toc-counter ez-toc-grey ez-toc-container-direction\">\n<div class=\"ez-toc-title-container\">\n<p class=\"ez-toc-title\" style=\"cursor:inherit\">How to Calculate Free Cash Flow and What It Means<\/p>\n<span class=\"ez-toc-title-toggle\"><\/span><\/div>\n<nav><ul class='ez-toc-list ez-toc-list-level-1 ' ><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-1\" href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/how-to-calculate-free-cash-flow\/#How_to_Calculate_Free_Cash_Flow_and_What_It_Means\">How to Calculate Free Cash Flow and What It Means<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-2\" href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/how-to-calculate-free-cash-flow\/#How_to_Calculate_Free_Cash_Flow_Under_IFRS_and_Other_Accounting_Systems\">How to Calculate Free Cash Flow Under IFRS and Other Accounting Systems<\/a><\/li><li class='ez-toc-page-1'><a class=\"ez-toc-link ez-toc-heading-3\" href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/how-to-calculate-free-cash-flow\/#How_to_Calculate_Free_Cash_Flow_Comparison_for_Best_Buy_and_Zendesk\">How to Calculate Free Cash Flow: Comparison for Best Buy and Zendesk<\/a><\/li><\/ul><\/nav><\/div>\n\n<style>.enteremail__large--inline{margin:60px auto!important}<\/style>\n<h2><span class=\"ez-toc-section\" id=\"How_to_Calculate_Free_Cash_Flow_and_What_It_Means\"><\/span>How to Calculate Free Cash Flow and What It Means<span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>If you have the three financial statements, including the Cash Flow Statement, it should be easy to determine a company&#8217;s &#8220;Cash Flow&#8221;: just take the \u201cNet Change in Cash\u201d from the bottom of the Cash Flow Statement, right?<\/p>\n<p><strong>WRONG!<\/strong><\/p>\n<p><strong>The problem is that companies can spend and receive their cash in many different ways, and not all these methods are \u201crequired\u201d and \u201crecurring.\u201d<\/strong><\/p>\n<p>For example, if a company issues Debt or Equity, both activities boost its cash flow \u2013 but neither one is necessarily \u201crequired\u201d for the business to keep operating.<\/p>\n<p>A company could spend cash buying Financial Investments, issuing Dividends, or repurchasing shares, but all those activities are also \u201coptional.\u201d<\/p>\n<p>To estimate the company\u2019s <strong>discretionary cash flow<\/strong>, therefore, we need a more precise definition.<\/p>\n<p>\u201cDiscretionary cash flow\u201d means \u201ccash flow <em>after<\/em> the company pays for what it needs to run its business and avoid being shut down by external parties such as lenders and the government.\u201d<\/p>\n<div class='code-block code-block-2' style='margin: 8px 0; clear: both;'>\n<div class=\"kb-adinsert-modal\">\n    <div class=\"kb-adinsert-top\">\n      <div class=\"media\">\n          <img decoding=\"async\" class=\"alignnone size-full wp-image-28448\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2024\/04\/24164120\/adv-fm-tile.png\" alt=\"PowerPoint Pro\" width=\"128\" height=\"128\" \/>\n      <\/div>\n      <div class=\"content\">\n          <h3>Master Financial Modeling for Investment Banking With <strong>BIWS Core Financial Modeling<\/strong><\/h3>\n      <\/div>\n    <\/div>\n    \n    <div class=\"full_text\">\n    \t<ul>\n        \t<li>\n            \t<h4>Become a financial modeling pro<\/h4>\n              <p>158 videos, detailed written guides, Excel files, quizzes, and more<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Complete 10+ detailed global case studies<\/h4>\n            <p>These include both the theory and the practical applications<\/p>\n\t\t\t    <\/li>\n          <li>\n          \t<h4>Prepare for your internship or full-time job<\/h4>\n            <p>Gain the skills you need to \u201chit the ground running\u201d on Day 1\n\n<\/p>\n\t\t\t  <\/li>\n      <\/ul>\n        \n      <a class=\"cta-link orange-button-medium\" href=\"https:\/\/breakingintowallstreet.com\/core-financial-modeling\/\" target=\"_blank\">Full Details<\/a>\n      \n      <a class=\"cta-link orange-button-medium bg-blue\" href=\"https:\/\/biws-support.s3.us-east-1.amazonaws.com\/Course-Outlines\/Core-Financial-Modeling-Course-Outline.pdf\" target=\"_blank\" rel=\"noopener\">Short Outline<\/a>\n    <\/div>\n<\/div><\/div>\n\n<p>We can define this metric in different ways, but a simple one is Free Cash Flow:<\/p>\n<ul>\n<li><strong>Free Cash Flow<\/strong> = Cash Flow from Operations (CFO) \u2013 Capital Expenditures (CapEx)<\/li>\n<\/ul>\n<p>There are other variations of Free Cash Flow, which we explore later in this course and the other written guides.<\/p>\n<p>But this initial definition is a good one because:<\/p>\n<ul>\n<li><em>Everything<\/em> in a company\u2019s \u201cOperating Activities\u201d section is required for its business \u2013 earning Net Income, paying for Inventory, collecting Receivables, etc.<\/li>\n<li>But almost every line item within Investing and Financing Activities is \u201coptional,\u201d except for Capital Expenditures.<\/li>\n<\/ul>\n<p>CapEx is a required item because companies need buildings, factories, and equipment to house employees, manufacture products, and sell them to customers.<\/p>\n<p>Even companies that sell services or software need buildings and computer equipment, and spending on both of them is considered CapEx.<\/p>\n<p><strong>Free Cash Flow lets us quickly and easily assess a company&#8217;s ability to generate cash flow from its business, including the cost of servicing its Debt and other long-term funding.<\/strong><\/p>\n<h2><span class=\"ez-toc-section\" id=\"How_to_Calculate_Free_Cash_Flow_Under_IFRS_and_Other_Accounting_Systems\"><\/span><strong>How to Calculate Free Cash Flow Under IFRS and Other Accounting Systems<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>One important note \u2013 especially under IFRS \u2013 is that this definition <em>assumes<\/em> that Cash Flow from Operations deducts Net Interest Expense, Preferred Dividends, Taxes, and all Lease Expenses.<\/p>\n<p>So, if the company you\u2019re analyzing has a CFO section that does <em>not<\/em> do that, you will need to adjust it for comparability purposes.<\/p>\n<p>For example, under IFRS, you should <strong>remove the Lease Depreciation add-back in CFO<\/strong> because it\u2019s not a true \u201cnon-cash expense.\u201d<\/p>\n<p>The company still pays the full Lease Expense in cash; splitting it into Interest and Depreciation elements does not change that.<\/p>\n<p>Here&#8217;s an example for Vivendi:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-22437 size-large\" title=\"Vivendi - Lease Depreciation\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075444\/Vivendi-Lease-Depreciation-1024x479.jpg\" alt=\"Vivendi - Lease Depreciation\" width=\"1024\" height=\"479\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075444\/Vivendi-Lease-Depreciation-1024x479.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075444\/Vivendi-Lease-Depreciation-300x140.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075444\/Vivendi-Lease-Depreciation-768x359.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075444\/Vivendi-Lease-Depreciation.jpg 1118w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><\/p>\n<p>Also, if CFO includes many items in the Non-Cash Adjustments section besides D&amp;A and Deferred Taxes, you may want to remove them to standardize the formula.<\/p>\n<p>&#8220;How to calculate Free Cash Flow&#8221; seems like a very simple topic\/formula &#8211; and it mostly <em>is<\/em> that simple under U.S. GAAP.<\/p>\n<p>Because of the changes to <a href=\"https:\/\/www.mergersandinquisitions.com\/lease-accounting\/\" target=\"_blank\" rel=\"noopener\">lease accounting<\/a> made in 2019, however, the calculation is often more complex for non-U.S. companies.<\/p>\n<h2><span class=\"ez-toc-section\" id=\"How_to_Calculate_Free_Cash_Flow_Comparison_for_Best_Buy_and_Zendesk\"><\/span><strong>How to Calculate Free Cash Flow: Comparison for Best Buy and Zendesk<\/strong><span class=\"ez-toc-section-end\"><\/span><\/h2>\n<p>Here\u2019s a quick comparison of Free Cash Flow for Best Buy (a U.S.-based retailer) and Zendesk (a U.S.-based software company):<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-22435 size-large\" title=\"How to Calculate Free Cash Flow\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075446\/How-to-Calculate-Free-Cash-Flow-1024x537.jpg\" alt=\"How to Calculate Free Cash Flow\" width=\"1024\" height=\"537\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075446\/How-to-Calculate-Free-Cash-Flow-1024x537.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075446\/How-to-Calculate-Free-Cash-Flow-300x157.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075446\/How-to-Calculate-Free-Cash-Flow-768x403.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075446\/How-to-Calculate-Free-Cash-Flow.jpg 1220w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><\/p>\n<p>For Best Buy, the interpretation is as follows:<\/p>\n<p>FCF is positive and growing, which is good, and the company doesn\u2019t seem to be \u201cplaying games\u201d by artificially cutting CapEx or changing its Working Capital to boost its FCF.<\/p>\n<p>In fact, the <a href=\"https:\/\/breakingintowallstreet.com\/kb\/financial-statement-analysis\/change-in-working-capital\/\" target=\"_blank\" rel=\"noopener noreferrer\">Change in Working Capital<\/a> (\u201cChanges in Operating Assets &amp; Liabilities\u201d) became <em>negative<\/em> in Year 3, but FCF increased anyway.<\/p>\n<p>Revenue is also growing each year, so it seems like Best Buy has a healthy business whose FCF is based on growth in that core business.<\/p>\n<p>For Zendesk, FCF is also positive and growing, but far more quickly than its Revenue Growth in two years.<\/p>\n<p>One reason is that the Changes in Operating Assets &amp; Liabilities are much less positive in Year 3, so FCF gets less of a boost from that.<\/p>\n<p>B<strong>ut there\u2019s another red flag here as well: Zendesk\u2019s Net Income is very negative, while its FCF is <em>positive.<\/em><\/strong><\/p>\n<p>Look at its statements, and you can quickly tell why:<\/p>\n<p><img decoding=\"async\" class=\"aligncenter wp-image-22436 size-large\" title=\"What is Free Cash Flow?\" src=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075445\/What-is-Free-Cash-Flow-1024x471.jpg\" alt=\"What is Free Cash Flow?\" width=\"1024\" height=\"471\" srcset=\"https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075445\/What-is-Free-Cash-Flow-1024x471.jpg 1024w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075445\/What-is-Free-Cash-Flow-300x138.jpg 300w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075445\/What-is-Free-Cash-Flow-768x353.jpg 768w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075445\/What-is-Free-Cash-Flow-1536x707.jpg 1536w, https:\/\/biwsuploads-assest.s3.amazonaws.com\/biws\/wp-content\/uploads\/2019\/04\/19075445\/What-is-Free-Cash-Flow.jpg 1687w\" sizes=\"(max-width: 1024px) 100vw, 1024px\" \/><\/p>\n<p>Generally, you want to see a <strong>positive and growing FCF<\/strong>.<\/p>\n<p>If FCF is negative, that means the company is not running a sustainable business by itself \u2013 it&#8217;s relying on outside financing to stay afloat!<\/p>\n<p>That\u2019s OK for short periods, such as the first few years of a startup\u2019s existence, but if a company stays like that for a decade, it raises serious questions.<\/p>\n<p>If FCF is <strong>negative<\/strong>, the first step is to ask, \u201cWhy? Is it temporary or permanent? Are the losses decreasing as the company grows?\u201d<\/p>\n<p>If FCF is becoming <em>more<\/em> negative as the company grows, stay away.<\/p>\n<p>If FCF is <strong>positive<\/strong>, you should also ask, \u201cWhy?\u201d before assuming it\u2019s a good thing.<\/p>\n<p>For example:<\/p>\n<ul>\n<li>Is the company\u2019s FCF growing because it\u2019s capturing more of the market, selling more, and achieving higher margins due to economies of scale? This is good.<\/li>\n<li>Is the company\u2019s FCF growing because of creative cost-cutting, or because it\u2019s reducing its annual CapEx spending? This is not so good.<\/li>\n<li>Is the company\u2019s FCF growing <em>despite<\/em> falling sales, because it\u2019s playing games with Working Capital or with CapEx and Depreciation? This is not good.<\/li>\n<\/ul>\n<p>In real life, you use Free Cash Flow in the Discounted Cash Flow (DCF) analysis for valuing companies, and also in the Leveraged Buyout (LBO) analysis for assessing the acquisition and sale of a company.<\/p>\n<p>You do <u>not<\/u> necessarily use the type of Free Cash Flow (CFO \u2013 CapEx) described here, but you do use variations of it.<\/p>\n<p>For more on how to calculate Free Cash Flow, please see our <a href=\"https:\/\/breakingintowallstreet.com\/kb\/discounted-cash-flow-analysis-dcf\/unlevered-free-cash-flow\/\" target=\"_blank\" rel=\"noopener noreferrer\">Unlevered Free Cash Flow tutorial<\/a>.<\/p>\n","protected":false},"excerpt":{"rendered":"<p>In this lesson, you\u2019ll learn what \u201cFree Cash Flow\u201d (FCF) means, why it\u2019s such an important metric when analyzing and valuing companies, how to interpret positive vs. negative FCF, and what different numbers over time mean \u2013 using calculations for Target, Best Buy, and Zendesk.<\/p>\n","protected":false},"featured_media":29349,"template":"","class_list":["post-20322","biws_kb","type-biws_kb","status-publish","has-post-thumbnail","hentry","kb_category-financial-statement-analysis"],"acf":[],"_links":{"self":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb\/20322","targetHints":{"allow":["GET"]}}],"collection":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/biws_kb"}],"about":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/types\/biws_kb"}],"wp:featuredmedia":[{"embeddable":true,"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media\/29349"}],"wp:attachment":[{"href":"https:\/\/breakingintowallstreet.com\/wp-json\/wp\/v2\/media?parent=20322"}],"curies":[{"name":"wp","href":"https:\/\/api.w.org\/{rel}","templated":true}]}}