A guide to free cash flow - definition and formula

Read our short guide to what free cash flow is, and how to calculate it for your business.

Helen Cockle

Calculating your business's free cash flow can help understand how well your company is performing. It gives you a better idea of how much cash your business is generating. This is why we've compiled this short guide to what free cash flow is and how to calculate it.

Free cash flow - explained

When calculating your company's free cash flow, you are calculating the capital that it is generating after business expenditure (eg rent, equipment, etc) has been deducted. Being aware of your company's free cash flow can help you understand how profitable your operation is.

Free cash flow
When calculating your company's free cash flow, you are calculating the capital that it is generating after business expenditure (eg rent, equipment, etc) has been deducted.

Calculating your company's free cash flow

There are two stages of calculating your business's free cash flow. At first, you need to determine your operating cash flow. This describes the revenue your business generates (including expenditure). The formula for operating cash flow is as follows: Operating Cash Flow = Net Income + Non-Cash Items + Changes in Working Capital.

Net income describes the amount your business has left after paying expenses. Non- cash items are depreciation, amortization, stock-based compensation, losses/gains on investments, and impairment charges. And last, changes in working capital describe the difference in net working capital year over year.

In a second stage, you then calculate your free cash flow as follows: Free Cash Flow = Operating Cash Flow – Capital Expenditures.

Calculating free cash flow
There are two stages of calculating your business's free cash flow. At first, you need to determine your operating cash flow.

Interpreting your company's free cash flow

Firstly, when calculating free cash flow, a negative number is not necessarily a cause of concern. It might only mean your company has made large investments which have led to lower free cash flows. It is helpful to focus on trends in your free cash flow to get an idea of the bigger picture.

Advantages and limitations of calculating your business's free cash flow

Being aware of your company's free cash flow can help gain insight into your business's financial performance and ultimately help improve cash flow management. Also, external parties such as investors and lenders might use the figure to determine whether you are likely to eg be able to pay dividends. However, it can sometimes be hard to compare a company's financial health against another solely based on free cash flow. Different accounting policies across different organizations tend to make comparison hard, even if they all calculate free cash flow figures.

Being aware of your company's free cash flow can help gain insight into your business's financial performance and ultimately help improve cash flow management.

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