Free Cash Flow (FCF) is the cash a company generates after paying for its operating costs and capital investments (CapEx). It’s the money left over to reinvest in the business, pay down debt, issue dividends, or return to shareholders.
- “We don’t count on reported earnings… what counts is cash—the kind you can spend.” – Warren Buffett, 2003 Letter to Shareholders
From Net Income to Free Cash Flow: Step-by-Step
Here’s how to calculate Free Cash Flow starting from Net Income:
1. Start with Net Income
This is profit after taxes and interest.
Think of it as:
Net Income = Revenue – Expenses – Taxes – Interest
2. Add Back Non-Cash Expenses
Items like depreciation and amortization reduce reported profit but don’t use cash.
Add these back—they’re accounting entries, not cash outflows.
3. Adjust for Changes in Working Capital
This captures short-term cash movements from daily operations.
Working Capital = Current Assets – Current Liabilities (excluding cash and debt)
So:
- Increase in Working Capital → subtract •
- Decrease in Working Capital → add
“Working capital changes are the difference between accounting profit and cash flow. Ignoring them inflates performance.” – Aswath Damodaran, Investment Valuation (2012)
4. Subtract Capital Expenditures (CapEx)
CapEx includes investments in equipment, property, or other long-term assets.
- It’s real cash out—and must be subtracted.
FCF Formula Recap
Free Cash Flow (FCF) =
Net Income
+ Non-Cash Expenses (Depreciation & Amortisation)
± Change in Working Capital
– Capital Expenditures
Example (Simplified)
Let’s say:
- Net Income = R1,000
- Depreciation = R200
- Inventory ↑ = R100
- Receivables ↑ = R100
- Payables ↑ = R50
- CapEx = R300
Working Capital = –100 (inventory) –100 (receivables) +50 (payables) = –150 Then:
FCF = 1,000 + 200 – 150 – 300 = R750
Why Working Capital Adjustments Matter
Accounting profit tells you what’s earned on paper—not what’s collected. FCF adjusts for the timing of cash movements in and out of the business.
- “Cash—not accounting profit—is what ultimately determines value.” – Benjamin Graham, paraphrased from Security Analysis
Working Capital: The Real-World Cash Story
Let’s break down the big three:
1. Accounts Receivable – Not All Sales Bring Cash
You made a sale, it’s in Net Income—but the customer hasn’t paid.
Adjustment: Subtract the increase in receivables.
You’re owed more—but haven’t been paid yet. That’s cash not yet received.
• Receivables ↑ = Subtract • Receivables ↓ = Add
2. Inventory – You Bought, But Haven’t Sold
Cash left the bank to buy stock, but the expense hasn’t hit yet.
Adjustment: Subtract the increase in inventory.
You spent cash to stock up—it hasn’t become revenue.
• Inventory ↑ = Subtract • Inventory ↓ = Add
3. Accounts Payable – You Owe, But Haven’t Paid
Cost is recorded in Net Income, but you still have the cash.
Adjustment: Add the increase in payables.
Delaying payment temporarily keeps cash in the business.
• Payables ↑ = Add • Payables ↓ = Subtract
Quick Analogy: Think of Working Capital Like Your Wallet
Wrap-Up Formula: With Intuition
Free Cash Flow =
Net Income
+ Depreciation & Amortisation
– Increases in Receivables & Inventory (cash out)
+ Increases in Payables (cash in)
– Capital Expenditures
Joe’s Bakery: A Mini Case
Joe reports R1,000 in net income. But:
- R300 is on credit (receivables ↑)
- R200 spent on unsold ingredients (inventory ↑)
- R100 owed to suppliers (payables ↑)
- R300 on new kitchen equipment (CapEx)
Then:
FCF = 1,000 – 300 – 200 + 100 – 300 = R300
Joe’s accounting profit was R1,000, but his actual free cash was only R300. That’s the power of understanding FCF.
Why Free Cash Flow Matters?
“The value of a business is the present value of its expected free cash flows.” – Aswath Damodaran, Damodaran on Valuation (2006)
FCF isn’t just a performance metric—it’s the engine behind valuation, reinvestment, and shareholder returns. It shows how much real cash is available after funding operations and future growth.
Bonus: FCFE vs FCFF
Note: FCFF is preferred when debt levels are unstable.
FCF vs EBITDA
EBITDA often overstates performance. FCF corrects for both reinvestment and cash tied up in operations.
One-Slide Summary
Free Cash Flow = Real Cash. Real Value.
FCF = Net Income
+ Non-Cash Expenses
± Working Capital
– CapEx
Adjust for:
- Receivables ↑ → Subtract (cash not collected)
- Inventory ↑ → Subtract (cash spent)
- Payables ↑ → Add (cash not paid)
“Cash is king. FCF tells you what’s left to reinvest, pay dividends, or reduce debt. It bridges accounting and reality.”
References
Berk, J. and DeMarzo, P. (2020) Corporate Finance. 5th ed. Harlow: Pearson.
Brigham, E.F. and Daves, P.R. (2021) Intermediate Financial Management. 14th ed. Boston: Cengage Learning.
Buffett, W.E. (1986) Letter to Berkshire Hathaway Shareholders. Available at: https://www.berkshirehathaway.com/letters/1986.html (Accessed: 8 April 2025).
Buffett, W.E. (2003) Letter to Berkshire Hathaway Shareholders. Available at: https://www.berkshirehathaway.com/letters/2003.html (Accessed: 8 April 2025).
Damodaran, A. (2006) Damodaran on Valuation: Security Analysis for Investment and Corporate Finance. 2nd ed. Hoboken: Wiley.
Damodaran, A. (2012) Investment Valuation. 3rd ed. Hoboken: Wiley.
Graham, B. and Dodd, D.L. (2008) Security Analysis. 6th ed. New York: McGraw-Hill.
Penman, S.H. (2013) Financial Statement Analysis and Security Valuation. 5th ed. New York: McGraw-Hill.
White, G.I., Sondhi, A.C. and Fried, D. (2003) The Analysis and Use of Financial Statements. 3rd ed. New York: Wiley.
