What Is Free Cash Flow?
Free cash flow is the cash left over after a company pays for its day-to-day operations and the capital investments needed to maintain and grow the business. The simplest formula is FCF = Cash Flow from Operations - Capital Expenditures, with both inputs taken from the cash flow statement.
Unlike net income, which is shaped by accrual accounting and non-cash charges, free cash flow measures actual cash generation, which is why many investors consider it the truest gauge of a company's economic output.
How It Works
Cash flow from operations starts with net income and adds back non-cash items like depreciation and amortization, then adjusts for changes in working capital such as receivables, inventory, and payables. Subtracting CapEx recognizes that a business must keep investing in equipment, facilities, and technology just to sustain itself.
In valuation work, analysts distinguish unlevered free cash flow, which is available to all capital providers and is used in a standard DCF, from levered free cash flow, which is what remains for equity holders after debt payments.
Example
Suppose a company reports $400 million of net income, $150 million of depreciation, a $50 million increase in working capital, and $200 million of capital expenditures. Cash flow from operations is $400 million + $150 million - $50 million = $500 million, so free cash flow is $500 million - $200 million = $300 million. That $300 million is what management can deploy toward dividends, buybacks, debt paydown, or M&A.
Why It Matters
Free cash flow is the lifeblood of intrinsic valuation: a discounted cash flow (DCF) model values a company as the present value of its projected future free cash flows. Companies that convert a high share of earnings into FCF tend to command premium valuations, while profit without cash generation is a classic warning sign.
It is also arguably the single most tested concept in investment banking interviews, where candidates are routinely asked to walk through the FCF build and explain how it feeds a DCF.
