Free cash flow (FCF) is the cash left over after a company pays the expenses that:
- Support its operations (like rent, energy, and payroll).
- Maintain/upgrade its physical assets (like equipment, buildings, and technology).
Earnings are a company’s after-tax profits. Also known as the net income, or the bottom line.
What’s the difference?
Earnings vs. Cash
Are earnings real profits?
No. Earnings are an accounting measure of a company’s performance. But they don’t represent real profits.
The company can’t use its earnings to buy goods, pay employees, fund new investments, or pay dividends to shareholders. Why?
Because to do these things, the company needs cash.
There’s a proportion of earnings that does not represent money coming in or out of the company.
For example, when you sell goods and agree with the client that they can pay you 5 months from now, the amount agreed upon is still considered in earnings, even though you didn’t get any cash for it yet.
This means when you evaluate a new project, you must determine its impact on the company’s available cash.
The incremental effect it has on the firm’s cash is the project’s free cash flow.
How do you calculate the free cash flow given the earnings?
Here are 3 simple steps:
#1) Add Depreciation
The first step is to add depreciation back to the earnings.
To get to the net income in the profit and loss statement, at some point you subtracted the depreciation of assets.
The problem is depreciations do not represent an outflow of cash. They are an accounting method that distributes the cost of a physical asset over its useful life.
Because depreciation is not an expense the company pays, we don’t include it in the free cash flow. Instead, we include the actual cash cost of the asset when it is purchased:
#2) Subtract Capital Expenditures
If your company buys a brand new machine for $150,000, that expense will not appear in the profit and loss statement. At least not all at once.
Instead, as we’ve seen above, you divide the 150 by the number of years you expect the machine to work well for you.
Even when you upgrade equipment (as opposed to buying new equipment), the total expense is not reflected in the profit and loss statement—only the increase in depreciation as a result of the increase in the value of the asset in the balance sheet, assuming the useful life of the equipment doesn’t go up a lot as a result of the upgrade.
Every year, little by little, the value of the machine in your books drops. This is a reflection of the machine getting older and not working as well, plus new technology creeping up.
Since we’re interested in the cash flows, we consider the full amount paid to acquire/upgrade the asset, instead of spreading it over a number of years.
This is why step 2 is to subtract the actual capital expenditures paid from earnings.
#3) Subtract Variations in Working Capital
Net Working Capital = Current Assets – Current Liabilities
= Cash + Inventory + Receivables – Payables
Working Capital is the difference between current assets and current liabilities.
“Current” means convertible in one year.
So, current assets are things like inventory and receivables (money clients owe you) that are expected to be converted to cash within a year. Cash is also a current asset, but we don’t take it into account to calculate the FCF.
Current liabilities are mostly payables (money you owe suppliers) you expect to pay creditors within a year.
To get to the free cash flow, we only consider variations in net working capital from year to year.
Why only variations and not the difference between current assets and liabilities every year?
A variation from one year to the other means you either got paid or paid someone. Both of these are not reflected in net income, because you already put it there the year before. Only the balance sheet changes to reflect more/less cash.
A variation can also mean you gave more credit to clients, or got in more debt with suppliers. In this case, both the P&L and the balance sheet change.
In all four situations, free cash flow is affected. Either you need to reflect movements of cash, or neutralize movements of non-cash.
Why do you subtract?
An increase in net working capital means either receivables went up, so more sales (but you didn’t get the cash). This affects free cash flow negatively, because you only want to keep real cash flows.
And/or it means payables went down—a cash outflow to pay off debt to suppliers. Also affects free cash flow negatively.
In either case, subtracting the positive difference in net working capital from one year to the other will rid net income of what’s not a real cash flow.
For a decrease, by subtracting a negative value you’re actually adding (minus minus equals plus). Working capital even can be negative.
A decrease happens because receivables went up. You got paid by customers, so positive impact on cash flow—so adding to earnings reflects that.
And/or payables went up so you’re more in debt with suppliers. Adding to earnings also reflects that additional credit you got.
The Bottom Line
Unlike earnings, free cash flow is a measure of profitability that excludes the non-cash expenses/gains of the income statement’s bottom line.
It also includes spending on assets and changes in working capital from the balance sheet.
When evaluating a project’s free cash flow, the first year will likely give you a result smaller than earnings. This happens because of the upfront investment in assets and the initial net working capital increase the project requires.
In later years, free cash flow exceeds the net income because depreciation is not a cash expense.
In the last year, the company recovers the investment in net working capital, further boosting the free cash flow.
