Free cash flow: cash left after equipment
Free cash flow (FCF) is the cash from operations left after paying for equipment. It is the money actually available to repay debt, pay dividends or fund the next investment, so it shows a company's room to manoeuvre more directly than profit.
Formulas
- Free cash flow = operating cash flow − purchases of property, plant and equipment
- Reinvestment rate = capital spending ÷ depreciation
- Cash flow adequacy = operating cash flow ÷ (capital spending + debt repayment + dividends)
- Debt service coverage = (operating profit + depreciation) ÷ debt repaid in the year
- Payout ratio = dividends paid ÷ net profit
Operating cash flow is estimated from the statements (method). Capital spending, repayments and dividends come from the cash flow statement, so these are calculated only for companies that publish one.
Worked example
Figures in units of 100 million KRW. Suppose this guide series' example company bought equipment for 1.2, repaid 0.6 of borrowings and paid 0.4 in dividends (values calculated by the Caveat engine).
| Measure | Current year |
|---|---|
| Operating cash flow (estimate) | 2.8 |
| Free cash flow | 1.6 |
| Reinvestment rate | 133.3% |
| Cash flow adequacy | 127.3% |
| Free cash flow ÷ borrowings | 35.6% |
| Debt service coverage | 6.83x |
| Payout ratio | 16.7% |
The company replaced equipment faster than it wore out and still covered equipment, repayments and dividends from operating cash, with some left over.
How to read it
- Negative free cash flow: the year's investment was not covered by operating cash, so the company borrowed or used savings. Natural during expansion; worth a funding review if it persists.
- Reinvestment rate well below 100%: equipment is not being replaced as fast as it wears out. Cash is kept now, but a bunched replacement bill may come later.
- Cash flow adequacy below 100%: operating cash did not cover equipment, repayments and dividends.
- High payout: much of the profit is leaving the company. For owner-run firms, read it with the owner's drawings.
Both sides: large free cash flow is not always good; it may mean needed investment is being postponed. A negative figure may be growth investment that pays back in later years. Judge it with the purpose of the spending.
Limitations
- Not calculated for companies without a cash flow statement, which includes most small private companies.
- Operating cash flow is an estimate and can differ from a reported cash flow statement.
- One year only, so businesses with long investment cycles swing widely from year to year.
- For reference only; it does not replace credit, investment or tax decisions.
See it in your own statements
Upload a balance sheet and income statement and Caveat calculates these for your company.
FAQ
- Is negative free cash flow dangerous?
- One year is hard to judge. In a year of heavy investment it is natural; if it persists while borrowing grows, review the funding structure.
- How do EBITDA and free cash flow differ?
- EBITDA comes before working capital, capital spending, interest and tax; free cash flow is closer to the cash actually left after them.
- What reinvestment rate is normal?
- Around 100% is needed to keep equipment at its current level; higher during growth. A long spell well below suggests ageing equipment.
- Which figures are needed?
- Two years of balance sheets and income statements to estimate operating cash flow, plus purchases of PP&E, debt repayments and dividends paid from the cash flow statement.
Country notes: Denmark
- Why can't free cash flow be calculated for a Danish company?
- Under § 22 of the Danish Financial Statements Act (Årsregnskabsloven), a small (reporting class B) company's annual report needs a balance sheet, income statement, notes and management review, but no cash flow statement; that becomes mandatory from class C (§ 78). Without capital spending, free cash flow cannot be calculated.