Free Cash Flow

Free cash flow is the cash left from operating business after deducting ongoing investments. It shows how much cash a company actually has freely available, for example for debt repayment, dividends, or acquisitions. It is therefore considered an important measure of financial strength.

In its simplest form it is calculated as operating cash flow less capital expenditure. In valuation a more precisely defined variant is normally used, free cash flow to the firm: it is derived from EBIT after tax plus depreciation and amortisation, less capital expenditure and less the change in working capital, and is discounted at the weighted average cost of capital in a discounted cash flow model. This differs from free cash flow to equity, which additionally reflects interest and net changes in debt.

The key difference from EBITDA lies in the two items EBITDA leaves out: capital expenditure and working capital. Those are precisely what tie up the capital of a growing company, so a business with high EBITDA and strong growth can perfectly well show negative free cash flow without anything being wrong. The measure is therefore meaningful only alongside the question of what the capital is used for and the distinction between maintenance and growth investment. For lenders free cash flow is the real benchmark, because interest and principal are serviced from it.

The separation of maintenance from growth investment is essential in practice, because only the former is unavoidable, and cash flow adjusted for growth capex shows what a company genuinely earns from its existing base. The change in working capital must also be reflected, since it ties up cash permanently in growing companies and cannot be treated as a one-off. For planning purposes cash flow is regularly presented in a base case and a downside scenario.