Free Cash Flow and Its Calculation

There are two basic definitions of free cash flow. Both the definitions are parallel to each other, but are used in two different contexts. In most cases, the free cash flow, which is also known as the FCF, is defined as the amount of liquid finances, that are left after a company makes all long term and short term payments and investments.

The FCF is used for dividends that are paid to the shareholders, who hold equity shares in the common stock. In a share holders language, the FCF is the profit of the company that is divided between the holders of equity shares, in the form of dividends or other perks and facilities, such as bonus shares.

In some cases, particularly in the United States, FCF implies the amount that is to be distributed within debt holders, preferred stock holders, equity holders, and almost any security or debt holders.

In most of the cases, the FCF valuation is done by the finance and accounts department, and the amount that is to be distributed within the stock and debt holders is derived by the board of directors.

The free cash flow formula can be used by many different people such as people from accounts department, major investors of the company, and also many shareholders of the equity stock. The simple formula that any person can use, goes as follows.

Free Cash Flow = Net Cash Flow From Operations - Capital Expenditures - Dividends

This formula is a generalized version of the concept of FCF. This kind of formula is usually used by senior management members at the end of weeks, months, and quarters, to quickly derive figures of FCF, for smaller time spans.

However, at the end of a financial year, when the company needs to close down and tally its books of accounts, a process is used for FCF calculation, which is given further.

Net income (can be derived form annual report or company's website) + Depreciation or Amortization (can be derived form annual report, company's website, or statutory requirements) - Change in Working Capital (current and previous balance sheets, subtract previous year from current year) = Cash flow from operations

Cash flow from operations - Capital expenditure (from annual report) = Free cash flow

This calculation will give you a figure of all the excess liquid finances. The dividends and returns that are issued may not be equal to the amount derived through this calculation. In some cases, the company also diverts some free cash to reserves and charitable activities.