Free Cash Flow (FCF)
$$\text{FCF} = \text{Operating Cash Flow} - \text{Capital Expenditure}$$
What is Free Cash Flow (FCF)?
Free cash flow (FCF) is the cash a business generates from its operations after funding the capital expenditure required to maintain and grow its asset base. The standard formula is: $$\text{FCF} = \text{Operating Cash Flow} - \text{Capital Expenditure}$$ A more granular derivation starts from EBITDA: $$\text{FCF} \approx \text{EBITDA} - \text{CapEx} - \Delta\text{Working Capital} - \text{Cash Taxes}$$ This version makes explicit the four principal claims on operating earnings before any capital is available to providers of finance.
The gap between EBITDA and FCF can be vast in capital-intensive or fast-growing businesses. A manufacturer with strong EBITDA that is simultaneously expanding capacity can have negative FCF for years. A software company with minimal CapEx and stable working capital converts nearly all of its EBITDA into cash.
FCF represents the discretionary cash available to the firm after it has paid all operating costs and reinvested in its business. This cash can be returned to equity holders via dividends or buybacks, used to repay debt, or deployed into acquisitions. It is the purest measure of economic value generation available from public financial statements.
When to use Free Cash Flow (FCF)
Use FCF — rather than net income or EBITDA — when you want to assess how much economic value a business is actually creating for its owners after accounting for reinvestment requirements. Use FCF yield (FCF / Market Cap) as a valuation metric comparable to earnings yield but more resistant to accounting manipulation. Use FCF when stress-testing a leveraged company's ability to service debt, since interest and principal must be paid in cash, not accounting profit.
Worked examples
| Company type | EBITDA | CapEx | ΔWorking Capital | Cash taxes | FCF | FCF / EBITDA |
|---|---|---|---|---|---|---|
| Software (SaaS) | $50M | $5M | −$2M | $8M | $39M | 78% |
| Manufacturer | $50M | $25M | $5M | $6M | $14M | 28% |
| Utility | $50M | $35M | $1M | $4M | $10M | 20% |
| Fast-growth retailer | $50M | $10M | $15M | $7M | $18M | 36% |
Common pitfalls
FCF can be temporarily inflated by under-investing in the business — a company that defers maintenance CapEx will report high FCF in the short term while its asset base deteriorates. Always assess CapEx relative to depreciation: if CapEx is persistently below depreciation, question whether the business is under-investing. FCF can also be distorted by working capital manipulation (stretching payables, accelerating collections) that is unsustainable over multiple periods.
Frequently asked questions
How is FCF different from EBITDA?
EBITDA measures earnings before capital allocation decisions; FCF measures what remains after the business has funded its reinvestment needs. The difference is driven by three factors: CapEx (often larger than D&A in growing businesses), changes in working capital (which can consume substantial cash in fast-growing companies), and cash taxes (which EBITDA ignores entirely).
What is a good FCF margin?
FCF margin (FCF / Revenue) varies enormously by industry. Asset-light software and professional services businesses routinely achieve 20–40%. Capital-intensive industries such as utilities, telecoms, and industrials may generate 5–15% despite healthy EBITDA margins. The most useful comparison is FCF margin relative to industry peers and to the same company's historical performance.
Why is FCF harder to manipulate than earnings?
Net income is subject to numerous accrual accounting choices — revenue recognition timing, depreciation methods, impairment decisions, and provisions — that can significantly affect reported profit without any corresponding cash movement. FCF is anchored to actual cash receipts and payments, making it far more difficult to inflate sustainably.