What You Should Know about “Free Cash Flow” for Accounting - dummies

What You Should Know about “Free Cash Flow” for Accounting

By John A. Tracy

The term free cash flow has emerged in the lexicon of finance and investing. This piece of language is not — let’s repeat, not — officially defined by the rule-making body of any authoritative accounting or financial institution. Furthermore, the term does not appear in cash flow statements reported by businesses.

Rather, free cash flow is street language, and the term appears in The Wall Street Journal and The New York Times. Securities brokers and investment analysts use the term freely (pun intended). Unfortunately, the term free cash flow hasn’t settled down into one universal meaning, although most usages have something to do with cash flow from operating activities.

The term free cash flow can refer to the following:

  • Net income plus depreciation expense, plus any other expense recorded during the period that doesn’t involve the outlay of cash — such as amortization of costs of the intangible assets of a business and other asset write-downs that don’t require cash outlay
  • Cash flow from operating activities as reported in the statement of cash flows, although the very use of a different term (free cash flow) suggests that a different meaning is intended
  • Cash flow from operating activities minus the amount spent on capital expenditures during the year (purchases or construction of property, plant, and equipment)
  • Earnings before interest, tax, depreciation, and amortization (EBITDA) — although this definition ignores the cash flow effects of changes in the short-term assets and liabilities directly involved in sales and expenses, and it obviously ignores that interest and income tax expenses in large part are paid in cash during the period

In the strongest possible terms, you are advised to be very clear on which definition of free cash flow a speaker or writer is using. Unfortunately, you can’t always determine what the term means even in context. Be careful out there.

One definition of free cash flow is quite useful: cash flow from operating activities minus capital expenditures for the year. The idea is that a business needs to make capital expenditures in order to stay in business and thrive. And to make capital expenditures, the business needs cash. Only after providing for its capital expenditures does a business have “free” cash flow that it can use as it likes. For this example, the free cash flow is

$1,515,000 cash flow from operating activities

-$1,275,000 capital expenditures

=$240,000 free cash flow

In many cases, cash flow from operating activities falls short of the money needed for capital expenditures. To close the gap, a business has to borrow more money, persuade its owners to invest more money in the business, or dip into its cash reserve. Should a business in this situation distribute any of its profit to owners? After all, it has a cash deficit after paying for capital expenditures. But, in fact, many businesses make cash distributions from profit to their owners even when they don’t have any free cash flow.