Cash flow is the core of any business—money is what keeps your company alive.
Your business’s free cash flows are an indicator of its financial health. They show how much money your company has to pay its balances and potentially invest back into growth.
Free cash flow yield takes that one step further and shows how much cash flow can be paid to a company’s investors per share that they own.
What is free cash flow?
Free cash flow (FCF) is the money a company has left over to repay its debts, pay out dividends to stakeholders, reinvest in itself, or save once it’s paid off all of its expenses. Free cash flow is a subset of cash flow, a broader term used to describe the money entering and leaving a company’s bank accounts.
FCF is reported on the balance sheet, a record of the funds flowing in and out of your company over a given period.
How to calculate free cash flow
To calculate your business’s FCF, take the total cash generated from your operations and subtract your capital expenditures (i.e., investments in long-term assets, like property, equipment, or patents).
Free cash flow formula
The basic free cash flow formula looks like this:
Free cash flow = cash from business operations - capital expenditures
A positive free cash flow means that a company generates cash, which, if high enough, could be reinvested in new products, marketing initiatives, or employees. It can also mean the company is in good financial shape and can afford to pay dividends to shareholders.
A negative FCF may indicate a company is struggling financially and may not have enough cash to invest in new products or employees. It may also show the company isn’t generating enough revenue to cover its capital expenses.
A negative FCF ratio could be a sign of trouble and may warrant further investigation by its owners.
Free cash flow example
Let’s say you’re a freelance social media marketer and need to calculate your free cash flow to see if it’s financially feasible to hire an assistant for 20 hours a month.
Your financials for the year look like this:
- Net income: $50,000
- Depreciation/amortization: $0
- Change in working capital: -$35,000
- Capital expenditure: $7,500
Your free cash flow will be: $50,000 + $0 - (-$35,000) - ($7,500) = $57,500.
This means you have $57,500 in available cash at your disposal, which you can use to hire an assistant. Or, you can reinvest the funds back into your business by buying a new laptop or marketing your services online.
The importance of free cash flow
Free cash flow is a valuable metric for businesses of all sizes, as it shows how much money a company has to draw on. Several players review this metric for different reasons:
- Business owner. To understand their company’s ability to generate cash, so they can manage their cash flow efficiently, improve business operations, and make strategic investment decisions on profitable ventures.
- Investors. To assess a company’s performance and whether it can raise new funds, pay out dividends to its shareholders, and pay back debts, so they can make informed investment choices.
- Lenders and creditors. To determine a company’s legitimacy and analyze its creditworthiness and ability to meet financial obligations.
- Analysts. To estimate a company’s intrinsic value and determine whether its share market price is undervalued or overvalued.
You’ll know whether a company has sufficient money to reinvest or pay out shareholders depending on its free cash flow yield ratio.
What is free cash flow yield?
Free cash flow yield describes how much free cash flow is available in relation to a company’s market capitalization—that is, relative to the company’s stock market value. Free cash flow yield is used to calculate how much money is paid out to stakeholders through interest and dividends.
Here is the free cash flow yield ratio formula:
Free Cash Flow Yield = Free Cash Flow Per Share / Market Price Per Share
Free cash flow yield is important because it shows how much money a company has available to pay dividends to shareholders.
Levered cash flow yield
A levered free cash flow yield is the amount of money your business has after it’s paid off all of its expenses and obligations.
Levered FCF yield is vital because it not only points to your company’s financial health but is also used to calculate how much funds are available to pay out to equity investors.
The formula for calculating levered free cash flow yield includes earnings before interest, taxes, depreciation, and amortization (EBITDA), as well as capital expenditures (CAPEX)—the money your company uses to buy fixed assets—and change in net working capital. The formula is:
Levered Free Cash Flow Yield = EBITDA − Net Working Capital − CAPEX − Mandatory Debt Payments
Unlevered cash flow yield
An unlevered free cash flow yield is the amount of money your business has before it’s paid off all of its financial obligations. A high unlevered FCF yield means a company has a lot of cash available to reinvest in its business or distribute to equity holders.
The formula for unlevered FCF yield includes earnings before interest, taxes, depreciation, and amortization (EBITDA), as well as capital expenditures (CAPEX). The formula is:
Unlevered Free Cash Flow Yield = EBITDA − CAPEX − Working Capital − Taxes
Levered free cash flow yields are typically higher than unlevered ones because they consider the impact of debt on a company’s finances. When a company carries large debts, its levered free cash flow is lower than its unlevered free cash flow because interest payments on the debt reduce the amount of money available for other purposes.
Free cash flow vs other financial statements
Free cash flow is a powerful metric financial analysis, but how does it compare to other financial statements? Here’s an overview of the key differences.
Free cash flow vs operating cash flow
Free cash flow is money left after accounting for capital expenditures or outflows. It represents cash that you can invest back into the business, repay creditors, or distribute to shareholders. Operating cash flow is the money a business generates from its primary revenue-producing operations. It’s more about a company’s liquidity and tells whether your business has enough cash to operate without needing outside financing.
Free cash flow vs working capital
Free cash flow is the money left over paying the costs of running a business, like rent, payroll, taxes, and inventory costs. You can reinvest these funds into the business or use them to pay down debt or pay dividends to shareholders and owners.
Working capital is the money you have left over to meet day-to-day and short-term obligations after accounting for current liabilities. It measures your company’s liquidity and short-term financial health.
Free cash flow vs EBITDA
Free cash flow is the money a business has left over after paying capital expenditures, such as payroll, equipment, inventory, rent, and taxes. The business is free to use these funds as it sees fit. EBITDA represents the money a business earns before accounting for essential and certain capital expenses. It provides a clear understanding of a company’s financial performance and profitability based purely on the strength of its core operations.
Free cash flow vs profit
Free cash flow (FCF) is the amount of money a business has left after accounting for operating expenses and capital expenditures. It measures a company’s profitability but is not equivalent to overall net income. Profit is what remains from a company’s revenues after deducting costs, and shows the immediate success or overall financial performance of a business.
Earn more free cash flow for your business
Free cash flow gives business owners and stakeholders, like investors, lenders, and analysts a picture of the money a company has available to spend at a given time, its performance, and its ability to stay in business.
Knowing how to calculate your company’s free cash flow and regularly monitoring and tracking it can help you position your business for the future, reduce debt, and make wise investment choices that drive growth.
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Free cash flow FAQ
What does a high cash flow yield mean?
A high cash flow yield means a company is generating significant cash flows relative to its cost and is often a positive sign of profitability.
How do you calculate cash flow yield ratio?
To calculate the cash flow yield ratio, divide the company's free cash flow by its market capitalization:
Free Cash Flow Yield = Free Cash Flow Per Share / Market Price Per Share
What is the FCF ratio?
The FCF ratio measures the free cash flow per share a business is expected to generate compared to its market value per share.
How do I calculate free cash flow?
For calculating free cash flow, use the following formula:
Free cash flow = Cash from business operations - Capital expenditures
How much free cash flow is good?
Most businesses typically aim for a free cash flow margin of 10% or higher, which shows the business is generating cash flow from its core activities. An FCF margin that’s below 5% can be a red flag—unless the business requires capital investments. (Source:Verified Metrics)
Is free cash flow yield a good metric?
Free cash flow yield is a valuable metric, particularly for financial analysts and investors, as it offers insights into a company’s financial health and growth potential. A high or positive FCF yield means a company is in good financial shape and can afford to pay dividends to shareholders, while a low or negative FCF yield may mean a business has limited capital and investors aren’t getting a good return on their investment.
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