Free cash flow formula helps us find out how much money a business has left after it pays for its bills and new tools. It shows the actual cash a company can use. This leftover money helps businesses pay debts, give rewards to investors, or grow bigger. So, understanding this formula is very important for students, new investors, and business owners.The free cash flow formula is very easy to learn. You subtract capital expenses from operating cash flow. This gives the real cash flow a company owns. This number shows if a company is healthy or not.Free cash flow tells you if the company is really earning or not. Even if profits look good on paper, cash flow tells the truth.
What is Free Cash Flow?
Free cash flow is the money a business has after paying for its basic needs and buying new tools or machines. It is the cash left with the company. It shows how strong or weak a company is.
Every company gets money from its work, which is called operating cash flow. But it also costs money to keep running. This includes buying machines or computers, called capital expenses. After paying for this, the amount left is called free cash flow.
Why is Free Cash Flow Important?
Free cash flow tells us if a company has real money to grow or pay its debts. A company may look good on paper but may have no money in hand. Free cash flow shows the truth. Investors use this to decide if they should invest. Students must also learn this, as it is part of many exams and interviews.
Some companies may earn a lot but still have less free cash flow because they spend too much. Others may earn less but spend wisely, and thus have more free cash flow. This makes them better choices.
Uses of free cash flow:
- To pay off loans
- To give dividends to investors
- To grow the business
- To buy other companies
- To save for tough times
So, this number is very useful for both the company and people who want to invest or work with the company.
What are Types of Free Cash Flow?
Free cash flow has more than one type. Each type shows different areas of a company’s financial health.
1. Free Cash Flow to the Firm (FCFF)
This type shows how much cash is available for both equity holders and debt holders. It includes taxes, interest, and all capital needs. It gives a full picture of the business.
Formula:
| FCFF = Net Income + Non-cash Expenses + Interest (1 – tax rate) – Changes in Working Capital – Capital Expenditure |
2. Free Cash Flow to Equity (FCFE)
This is the cash left for shareholders after all expenses and loan payments. It is more useful for people who want to invest in the company’s shares.
Formula:
| FCFE = Net Income + Depreciation – Capital Expenditure – Change in Working Capital + Net Borrowing |
3. Levered Free Cash Flow
This shows the real cash after the company pays all its loans. It is very helpful to know if the company can run its daily work easily.
Free Cash Flow Formula
The most common free cash flow formula is:
| Free Cash Flow = Operating Cash Flow – Capital Expenditures |
Where,
- Operating Cash Flow (OCF):
This is the total money a company makes from its main work. You get this from the cash flow statement. - Capital Expenditure (CapEx):
This is the money spent on new machines, land, or computers. This is important for future growth.
When we subtract capital expenditure from operating cash flow, we get the actual free cash that the company can use. This number is very helpful for investors.
Example of Free Cash Flow Formula
Let’s say a company has:
- Operating Cash Flow = ₹1,00,000
- Capital Expenditure = ₹30,000
Free Cash Flow = ₹1,00,000 – ₹30,000 = ₹70,000
This means the company has ₹70,000 left after spending on its growth. This cash can be used for dividends, paying loans, or saving.
Calculation of Free Cash Flow
Now let us see how to calculate free cash flow in a step-by-step way. This part helps in understanding how real companies work.
Step-by-step Free Cash Flow Calculation
- Get the Cash Flow from Operating Activities
Go to the company’s financial report. Look at the cash flow statement. - Find the Capital Expenditure
This is also present in the same statement. Usually shown as “Purchase of property, plant and equipment”. - Apply the Free Cash Flow Formula
Subtract capital expenditure from operating cash flow.
Example:
| Item | Amount (₹) |
| Operating Cash Flow | ₹2,00,000 |
| Capital Expenditure | ₹80,000 |
| Free Cash Flow | ₹1,20,000 |
This means the company has ₹1,20,000 free cash to use in any way.
Relevance to ACCA Syllabus
Free cash flow (FCF) forms part of financial management and performance measurement. ACCA students must learn how to analyze cash flow statements, evaluate investment opportunities, and interpret liquidity and solvency through free cash flow. This is crucial for papers like FM (Financial Management) and AFM (Advanced Financial Management).
Free Cash Flow Formula ACCA Questions
Q1. What does the basic free cash flow formula calculate?
A) Net profit before tax
B) Operating income less depreciation
C) Operating cash flow minus capital expenditure
D) Gross cash inflow from sales
Answer: C) Operating cash flow minus capital expenditure
Q2. Which of the following is NOT required in calculating Free Cash Flow to the Firm (FCFF)?
A) Depreciation
B) Capital Expenditure
C) Net Borrowing
D) Change in Working Capital
Answer: C) Net Borrowing
Q3. Why is Free Cash Flow important in business analysis?
A) It measures net profit
B) It shows shareholder equity
C) It reflects actual available cash for use
D) It indicates inventory turnover
Answer: C) It reflects actual available cash for use
Q4. Which financial statement is primarily used to derive free cash flow?
A) Balance Sheet
B) Cash Flow Statement
C) Statement of Changes in Equity
D) Income Statement
Answer: B) Cash Flow Statement
Relevance to CMA (US) Syllabus
In Part 1: Financial Planning, Performance and Analytics, US CMA emphasizes cash flow analysis, working capital management, and long-term financial planning. Understanding the free cash flow formula helps CMA candidates assess a company’s ability to fund operations and capital investment without external financing.
Free Cash Flow Formula US CMA Questions
Q1. What is the significance of a positive free cash flow in a company?
A) The company depends on external funding
B) The company is overleveraged
C) The company can meet obligations and reinvest
D) The company has excess inventory
Answer: C) The company can meet obligations and reinvest
Q2. Free Cash Flow = Operating Cash Flow – ______ ?
A) Net Income
B) Depreciation
C) Capital Expenditures
D) Total Liabilities
Answer: C) Capital Expenditures
Q3. Which of the following improves free cash flow?
A) High capital expenditures
B) Low operating cash inflow
C) Reduced capital expenditures
D) Increase in non-operating income
Answer: C) Reduced capital expenditures
Q4. Which measure is best for evaluating a company’s internal ability to fund investments?
A) Gross Profit
B) Free Cash Flow
C) Retained Earnings
D) EBITDA
Answer: B) Free Cash Flow
Relevance to CFA Syllabus
In CFA Level 1 and Level 2, free cash flow plays a vital role in valuation models, particularly in equity valuation and corporate finance. Understanding how to compute Free Cash Flow to Firm (FCFF) and Free Cash Flow to Equity (FCFE) is central to discounted cash flow (DCF) techniques.
Free Cash Flow Formula CFA Questions
Q1. FCFF includes all of the following EXCEPT:
A) EBIT after taxes
B) Depreciation
C) Net Borrowing
D) Capital Expenditure
Answer: C) Net Borrowing
Q2. FCFE is best used in valuation of:
A) Bond Investments
B) Equity Shares
C) Real Estate
D) Inventories
Answer: B) Equity Shares
Q3. What is the impact of increasing working capital on free cash flow?
A) It increases free cash flow
B) It has no effect
C) It decreases free cash flow
D) It doubles free cash flow
Answer: C) It decreases free cash flow
Q4. Why is FCFF preferred in firm valuation?
A) It excludes taxes
B) It reflects cash for shareholders only
C) It covers both debt and equity holders
D) It uses net income instead of EBIT
Answer: C) It covers both debt and equity holders
Relevance to CPA (US) Syllabus
In BEC and FAR sections of the CPA exam, understanding cash flow management, valuation models, and financial statement interpretation is essential. Free cash flow is often used to assess business value, credit risk, and internal financing capabilities.
Free Cash Flow Formula US CPA Questions
Q1. In business valuation, why is free cash flow used over net income?
A) FCF is less volatile
B) FCF includes revenue
C) FCF shows actual liquidity
D) FCF is not tax adjusted
Answer: C) FCF shows actual liquidity
Q2. Free Cash Flow to Equity differs from FCFF by including:
A) Tax rate
B) Depreciation
C) Net Borrowing
D) EBIT
Answer: C) Net Borrowing
Q3. Which of the following statements is correct?
A) FCF is found on the Balance Sheet
B) FCF excludes capital spending
C) FCF = Net Income – CapEx
D) FCF = OCF – CapEx
Answer: D) FCF = OCF – CapEx
Q4. Which scenario would result in higher free cash flow?
A) Increase in CapEx
B) Decrease in Operating Income
C) Stable revenues and reduced CapEx
D) Increase in Working Capital
Answer: C) Stable revenues and reduced CapEx
