Free Cash Flow

An entrepreneur friend keeps close tabs on how public software businesses with recurring revenue are valued. He feels confident that in a high-interest-rate environment, free cash flow will play a bigger role in the valuation of these and other types of public companies than it has in the last decade.

It occurred to me that most people likely don’t know what free cash flow means. Free cash flow is a measure of how much cash a company generates (or consumes) that’s available for management to use at their discretion. For example, they may use it to pay dividends or for share buybacks. It’s important to note that free cash flow is different from net income (net profit)—mainly because of accounting rules. For example, some things that add to or subtract from net income don’t involve the company spending or receiving cash (e.g., depreciation). Companies can lack profitability but still generate free cash, and vice versa.

Here’s the formula: free cash flow = operating cash flow – capital expenditures

Operating cash flow can be found on the statement of cash flows. I won’t get into the details, but it’s basically how much cash company operations generate. It’s different than capital cash generated or spent from investing and financing activities. If a company sells widgets, it measures how much cash it consumed or generated just from selling widgets, not from investing the company’s cash or raising debt or equity.

Capital expenditures can also be found on the statement of cash flows. This is usually a measure of how much capital was spent on assets that will be depreciated over a period. Think buildings or pieces of machinery. Buying assets isn’t an operating expense, but it does reduce cash available for management to use and thus reduces free cash flow.

Free cash flow is a good concept for entrepreneurs to understand.