Free cash flow (FCF) is the cash generated by a business after accounting for operating expenses and capital expenditure. It represents the cash available for distribution to shareholders, debt repayment, acquisitions, or reinvestment. FCF is considered one of the most important financial metrics because it is difficult to manipulate.
Formula
FCF = Operating Cash Flow - Capital ExpenditureIn Depth
Free cash flow strips away accounting conventions to reveal the true cash-generating power of a business. While earnings can be influenced by depreciation policies, revenue recognition choices, and accrual timing, free cash flow measures the actual cash a company produces — making it a favourite metric of sophisticated investors and analysts.
The most common formula is: FCF = Operating Cash Flow - Capital Expenditure. Some analysts use: FCF = Net Income + Depreciation & Amortisation - Changes in Working Capital - CapEx. Both should yield similar results.
FCF can be further categorised. Free Cash Flow to Firm (FCFF) is cash available to all capital providers (equity and debt holders). Free Cash Flow to Equity (FCFE) deducts debt repayments and interest, showing cash available specifically to equity holders.
For FP&A teams, FCF forecasting is essential for several reasons. It determines how much cash is available for dividends, share buybacks, or reinvestment. It informs borrowing needs — negative FCF periods require external funding. It is the basis for DCF (Discounted Cash Flow) valuations, which are the gold standard for intrinsic value assessment.
FCF conversion — the ratio of FCF to net income — measures the quality of earnings. A company with consistently high FCF conversion (above 80-90%) is generating real cash from its reported profits. Low FCF conversion may indicate aggressive accounting, excessive CapEx requirements, or working capital inefficiency.
For UK companies, FCF should be assessed after accounting for corporation tax payments, VAT settlements, and any other mandatory cash outflows specific to the UK regulatory environment.
Real-World Example
A UK software company reports £2.5M operating cash flow and £800K CapEx (primarily capitalised development costs), yielding £1.7M free cash flow. Net income is £1.4M, so FCF conversion is 121% — strong, indicating that non-cash charges and working capital movements are generating more cash than the accounting profit suggests. The board uses the FCF to fund a £500K special dividend and retain £1.2M for growth.
Related Terms
A cash flow statement reports the inflows and outflows of cash over a period, divided into three cat...
Net income, also called net profit or the bottom line, is the total profit remaining after all expen...
Capital expenditure (CapEx) is money spent to acquire, upgrade, or maintain long-term physical or in...
Operating expenditure (OpEx) refers to the day-to-day costs of running a business that are expensed ...
A DCF (Discounted Cash Flow) model values a company or project by projecting future free cash flows ...
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