The Multiple Meanings of “Free Cash Flow” - dummies

The Multiple Meanings of “Free Cash Flow”

You’ll encounter the term free cash flow in finance circles — but the term hasn’t been officially defined. Furthermore, free cash flow doesn’t appear in cash flow statements reported by businesses. Rather, the term is pure Wall Street lingo. Most usages of the term, however, have something to do with cash flow from operating activities.

The term free cash flow has been used to mean 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 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 most of interest and income tax expenses are paid in cash during the period.

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.

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 paying for its capital expenditures does a business have “free” cash flow that it can use as it likes.

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. Many businesses make cash distributions from profit to their owners even when they don’t have any free cash flow.