The formula for FCF is free cash flow = cash flow from operating activities minus capital expenditures. Both inputs are read off one completed statement of cash flows: the operating activities subtotal, and the cash spent to buy property, plant and equipment, which sits inside the investing activities section. Free cash flow is not a subtotal that statement produces, and no accounting standard defines it, so the figure means only what the person presenting it says it means.
The Formula for FCF and Its Two Inputs
FCF = cash flow from operating activities - capital expendituresThe Commission’s staff describes the calculation the same way. Some companies present a measure of free cash flow, typically calculated as cash flows from operating activities as presented in the statement of cash flows under GAAP, less capital expenditures (SEC Compliance and Disclosure Interpretations, Non-GAAP Financial Measures, Question 102.07).
Each input has a fixed home on the statement. The operating section reports the cash a company received from or used in its operating activities, and under the indirect method, which nearly all issuers use, it gets there by adjusting net income for non-cash items such as depreciation and for cash used or provided by other operating assets and liabilities (SEC, Beginners’ Guide to Financial Statements, SEC, The Statement of Cash Flows: Improving the Quality of Cash Flow Information Provided to Investors). The investing section carries purchases and sales of long-term assets such as property, plant and equipment (SEC, Beginners’ Guide to Financial Statements). Capital expenditure is the purchase side of that second line, the cash paid to acquire or improve fixed assets.
The rest of that section stays out of the formula. Proceeds from selling old equipment, purchases of investment securities and cash paid for an acquisition all sit there too, and none of them is a capital expenditure.
A Worked Example
Say a client’s statement of cash flows for the year closes on the amounts below, and the equipment purchase is the only capital expenditure in the investing section.
Cash flow from operating activities 412,000
Purchases of property and equipment (96,000)
Purchases of investment securities (50,000)
Proceeds from sale of old equipment 8,000
FCF = 412,000 - 96,000 = 316,000Only the equipment purchase enters the subtraction. Pulling in the securities purchase or the sale proceeds would change the answer without changing a dollar of cash.
What the Number Does Not Mean
The measure does not have a uniform definition and its title does not describe how it is calculated, so a clear description of how it was calculated, along with the necessary reconciliation, should accompany it wherever it is used (SEC Compliance and Disclosure Interpretations, Non-GAAP Financial Measures, Question 102.07). Two people can hand you a figure under this name and neither of them is wrong, so the definition travels with the number or the number is not usable.
The name also oversells it. Free cash flow should not be used in a way that inappropriately implies it represents the residual cash flow available for discretionary expenditures, because many companies have mandatory debt service requirements or other non-discretionary expenditures that are not deducted from the measure (SEC Compliance and Disclosure Interpretations, Non-GAAP Financial Measures, Question 102.07). Loan principal and distributions to owners still have to come out of it.
Free cash flow is a non-GAAP measure, as EBITDA is, and the disclosure machinery that goes with that status, Regulation G and Item 10(e) of Regulation S-K, is set out in EBITDA. One restriction lands squarely on this one. Free cash flow is a liquidity measure that must not be presented on a per share basis (SEC Compliance and Disclosure Interpretations, Non-GAAP Financial Measures, Question 102.07), and the general rule behind that is that non-GAAP liquidity measures that measure cash generated must not be presented on a per share basis in documents filed or furnished with the Commission (SEC Compliance and Disclosure Interpretations, Non-GAAP Financial Measures, Question 102.05).
Where a CPA Firm Meets the Number
A firm meets free cash flow at close, while building the statement the formula reads from. Both inputs are decided by classification, so an item dropped into the wrong section moves the measure without a dollar of cash moving. Accurately classifying cash flows as operating, investing, or financing activities is paramount to investors understanding the nature of the activities that generated and used cash during the period, and staff in the SEC’s Office of the Chief Accountant have said they do not find persuasive the argument that an error is immaterial because it is a classification error only, since classification itself is the foundation of the statement (SEC, The Statement of Cash Flows: Improving the Quality of Cash Flow Information Provided to Investors).
That risk shows up in the record. The statement of cash flows has consistently been a leading area of financial statement restatements, and deciding whether a cash flow is operating, investing or financing can at times require significant judgment (SEC, The Statement of Cash Flows: Improving the Quality of Cash Flow Information Provided to Investors). The codification topic behind that judgment is ASC 230. The staff statement itself addresses issuers who file with the Commission and their auditors and carries no legal force, and a private client’s statement answers to nobody at the SEC, but the classification call inside it is the same one.
The recurring work is small. Tie the capital expenditure line back to the additions in the fixed asset roll-forward, keep assets acquired by note or by lease out of it because no cash moved, and keep items that belong in investing out of the operating section. When a lender asks for a covenant package or a buyer asks for a valuation, the free cash flow figure comes off those same two lines, and whoever asked will define the measure their own way.
What Free Cash Flow Is Confused With
FCFF and FCFE
Free cash flow to the firm and free cash flow to equity are the cash flows available to, respectively, all of the investors in a company and to its common stockholders. They are not readily available data, so an analyst computes them from the financial statements, frequently by starting with net income, and free cash flow to the firm can also be built from EBIT or EBITDA (CFA Institute, Free Cash Flow Valuation).
The claimant is the distinction, not the starting line. Both variants can also be calculated by starting from cash flow from operations, the same subtotal the plain formula reads, with free cash flow to the firm adding back after-tax interest and subtracting fixed capital investment, and free cash flow to equity subtracting fixed capital investment and adding net borrowing (CFA Institute, Free Cash Flow Valuation). Fixed capital investment is spending on long-lived assets, and net borrowing is new debt raised less debt repaid.
Interest is what lenders are paid and borrowing is what they advance, so those two adjustments are what select whose cash the figure measures. The plain formula makes neither of them, so its answer and theirs do not have to agree.
EBITDA
EBITDA never subtracts what a business spent on long-lived assets, and free cash flow does, which is the gap between them. Earnings components such as net income, EBIT, EBITDA and cash flow from operations should not be used as cash flow measures to value a firm, because those components either double-count or ignore parts of the cash flow stream (CFA Institute, Free Cash Flow Valuation). EBITDA rebuilds a figure upward from net income by adding four charges back, and it stops there.
A Forward Cash Forecast
Free cash flow looks backward, at a period the books have already closed. A rolling weekly cash flow forecast projects receipts and payments that have not happened yet, so it answers a question about the coming quarter rather than about the year just reported.
Common Questions
There is no best one, because the measure has no uniform definition (SEC Compliance and Disclosure Interpretations, Non-GAAP Financial Measures, Question 102.07). Operating cash flow less capital expenditures is the version the staff describes, so use that one and say alongside the figure that you did.
Conversion divides free cash flow by an earnings figure for the same period, so it reports what share of reported earnings arrived as cash. There is no standard version of it, because the numerator has no uniform definition and no standard fixes which earnings figure belongs underneath it. The ratio says nothing until both definitions are stated beside it.
They are not alternatives. Free cash flow is a measure of one period that has already closed. Discounted cash flow valuation views the intrinsic value of a security as the present value of its expected future cash flows (CFA Institute, Free Cash Flow Valuation), so it is a method, and a free cash flow figure is one of the inputs it discounts. Where a valuation method sits among the three generally accepted approaches is covered in valuation.
Accountably places trained offshore accountants and tax preparers inside US CPA and EA firms, and a firm can put a real block of its own close and reporting work through a trial task before a live engagement depends on it.
