Net income can be shaped by accounting choices. Cash is harder to dress up. That's why patient investors watch free cash flow, the cash a business generates after paying to keep and grow its operations. This is Part 8 of our Read the Numbers series, and it builds directly on the cash flow statement.
The basic definition
The most common version is operating cash flow minus capital expenditures. Operating cash flow comes from the first section of the cash flow statement, and capital expenditures are the purchases of property and equipment in the investing section.
The company earned $96,000 but, after reinvesting $60,000 in equipment, had $51,000 of free cash. Neither number is wrong; they answer different questions.
An important caution from the SEC
Free cash flow isn't a formal accounting measure, so definitions vary. In its staff guidance on non-GAAP measures, the SEC says the term has no uniform definition and its title doesn't describe how it's calculated, so a company presenting it should provide a clear description of the calculation and the reconciliation. The staff also says it shouldn't be used in a way that implies it's residual cash available for discretionary spending, since many companies have mandatory debt payments or other non-discretionary expenditures that aren't deducted. And it's a liquidity measure that must not be presented on a per-share basis.
In plain terms: before relying on any free cash flow number, find out how that company or data provider calculated it. Two sources can report different figures for the same company.
The warning sign: profit up, free cash flow down
| Year | Net income | Operating cash flow | Capital expenditures | Free cash flow |
|---|---|---|---|---|
| Year 1 | $80,000 | $95,000 | $25,000 | $70,000 |
| Year 2 | $90,000 | $80,000 | $40,000 | $40,000 |
| Year 3 | $100,000 | $60,000 | $50,000 | $10,000 |
Net income rose 25% over the period while free cash flow fell by about 86%. Reported profit looks like a success story; the cash tells a different one. The usual cause is the pattern we walked through in Part 2: customers paying slower, inventory building up, or heavy spending to maintain growth. Any one year can be noise, but a multi-year divergence deserves an explanation in the 10-K's management discussion.
Where free cash flow can mislead
- Lumpy spending. Capital expenditures can be uneven. A company that skipped investment this year will show a flattering number that may not last.
- Maintenance versus growth. Some capital spending just keeps the business running, and some expands it. Companies rarely separate them cleanly.
- Non-cash pay. Stock-based compensation is a real cost to shareholders but is added back in operating cash flow, which can make free cash flow look better than the economics.
- Debt payments aren't deducted. As the SEC notes, free cash flow isn't the same as cash available to do whatever you like; debt service still comes due.
- Timing. Working-capital swings, such as collecting receivables early, can lift a single year's cash flow without any change in the business.
Using it well
A sensible approach is to look at free cash flow over several years and compare it with net income. A healthy business tends to turn profit into cash fairly consistently. When the two diverge for years, the question becomes why, and the answer is usually in the notes and the management discussion.
Common questions
What is free cash flow?
Free cash flow is commonly defined as cash from operating activities minus capital expenditures. It's the cash left after paying to maintain and expand the business. Because it isn't a formal accounting measure, the exact formula varies between companies and data providers.
Is free cash flow better than net income?
They answer different questions. Net income reflects accounting profit, including non-cash items and sales not yet collected. Free cash flow reflects cash actually generated after investment. Looking at both, and the gap between them over time, is more informative than either alone.
Why can free cash flow be negative for a healthy company?
A company investing heavily in growth, such as building factories or stocking inventory ahead of expansion, can have negative free cash flow even while profitable. What matters is whether the spending is producing returns and how the company is funding it.
- SEC Division of Corporation Finance, Non-GAAP Financial Measures: Compliance and Disclosure Interpretations
- SEC, Beginners' Guide to Financial Statements
- How to Read a Balance Sheet in Five Minutes
- How to Read an Income Statement in Five Minutes
- How to Read a Cash Flow Statement: Why Profit Isn't the Same as Cash
- The Three Financial Statements, Explained as One Story
- How to Read a 10-K Without Falling Asleep
- How to Read an Earnings Report: Beat, Miss, Guidance, and Why Good News Can Sink a Stock
- The 10 Financial Ratios That Matter, With the Formula and the Catch
- P/E Ratio Explained: What It Tells You and Why a Low One Can Be a Trap
- Dividend Payout Ratio: How to Tell Whether a Dividend Is Safe
- How to Read a Fund Fact Sheet, and Why the Expense Ratio Comes First