Free cash flow is the cash a business has left after it pays to keep itself running and to grow. That's it. One subtraction, two numbers, both sitting in a filing anyone can download for free.
I weight it more heavily than any other single number, and I have for most of four decades. Here's why, and here's how to do it.
The free cash flow formula
Both numbers come off the cash flow statement in a company's 10-K or 10-Q. Operating cash flow is near the top, usually labeled "net cash provided by operating activities." Capital expenditures sit a little further down under investing activities, usually labeled "purchases of property, plant, and equipment." Subtract the second from the first.
You can do this in about ninety seconds with a filing and a calculator. Most investors never do it once.
Why free cash flow beats earnings
Net income is an opinion. Not a lie necessarily, but an opinion, assembled from judgment calls about when to recognize revenue, how fast to depreciate an asset, what to reserve for, what to capitalize instead of expense. All of it legal. All of it discretionary.
Cash is different. Either it showed up in the bank or it didn't.
So watch the gap between net income and operating cash flow. When reported earnings climb and cash doesn't follow, something is wrong. Either the business has a problem it hasn't admitted, or the accounting has drifted somewhere it shouldn't. Enron's reported earnings looked wonderful right up until anyone bothered to check the cash. The cash flow statement is where that kind of story breaks first.
Net income is an opinion. Cash either showed up in the bank or it didn't.
A worked free cash flow calculation
Here's the bottom of a cash flow statement for a company I'll call XYZ Corp.
| XYZ Corp, year ended December 31 | $ millions |
|---|---|
| Net income | 420 |
| Depreciation and amortization | 310 |
| Changes in working capital | (70) |
| Net cash provided by operating activities | 660 |
| Purchases of property, plant, and equipment | (240) |
| Free cash flow | 420 |
XYZ generated $660 million in operating cash and spent $240 million maintaining and expanding its asset base. Free cash flow is $420 million. Note that it happens to match net income exactly here, which is a coincidence I built into the example on purpose: those two numbers are not the same thing and matching them tells you nothing. What matters is that the cash is real and that it has somewhere useful to go.
That $420 million is what pays dividends, buys back stock, retires debt, or funds the next acquisition. A company generating it has choices. A company that isn't has to go ask a bank or the market for permission.
The four ratios worth building on top of it
The raw number tells you the business produces cash. The ratios tell you whether that's enough, and whether you're paying a sensible price for it. These are the thresholds in my own working framework, not universal laws, and they are starting points for a conversation rather than the end of one.
Free cash flow yield. Free cash flow divided by market capitalization. Above 5% is usually attractive. The floor I insist on is simpler: the yield has to beat what the 10-year Treasury is paying at the time I'm looking. If a stable, mature business can't produce more cash yield than the risk-free rate, I'm being paid nothing for taking equity risk, and I should go buy the Treasury.
Free cash flow to sales. Free cash flow divided by revenue. Above 10% is strong. This tells you how much of every dollar of sales actually survives the trip through the business and comes out the other end as cash. Businesses that convert at a high rate are usually high quality, and the reason is structural rather than clever.
Free cash flow to debt. Free cash flow divided by total debt. Above 0.2 suggests the debt is manageable, meaning the company could retire it from cash flow in about five years if it chose to. The lower that ratio runs, the more a bad year hurts.
Free cash flow growth. Not a threshold so much as a direction. I want to see the number rising over five years. Consistent and growing beats large and erratic.
Why two sources will give you different numbers
Here is something that trips up people new to this. Free cash flow is not a standardized line item. It isn't defined under GAAP, companies aren't required to report it, and the data providers all calculate it slightly differently. Some subtract only maintenance capital spending. Some net out acquisitions. Some adjust for stock-based compensation, some don't.
So two screeners can show you two free cash flow figures for the same company in the same year, and neither one is wrong exactly. They're answering slightly different questions.
The fix is not complicated. Know which definition you're using, use it consistently across every company you compare, and when a number looks surprising, go pull the actual filing and do the subtraction yourself. Unless I say otherwise, mine is operating cash flow minus capital expenditures, straight off the statement, no adjustments.
Maintenance capex versus growth capex
Not all capital spending means the same thing, and the cash flow statement won't separate it for you.
Maintenance capital expenditure is what a company must spend just to keep running what it already has. Replace the trucks. Refit the plant. Upgrade the servers before they fail. That spending buys no growth. It's the cost of staying in business, and it never stops.
Growth capital expenditure builds something new. New capacity, new locations, a new product line. It depresses free cash flow today in exchange for cash flow that may not arrive for years.
Both reduce the number. They don't mean the same thing. A company whose free cash flow is thin because it's building a second factory is in a different position from one whose free cash flow is thin because its existing factory keeps breaking. Management discussion in the 10-K will often give you enough to tell the two apart. Read it.
When negative free cash flow is fine
It can be, and I don't want to leave the impression otherwise.
A young company growing quickly and investing hard may burn cash for years and still be a fine investment, as long as the spending is building something that eventually produces returns. That's the whole premise of growth investing, and some of the best businesses of the last thirty years looked terrible on this measure early on.
A mature business in a stable industry with negative free cash flow is a different animal. That business should be self-funding by now. If it isn't, find out why before you buy it, not after.
One more caution: free cash flow is lumpy. Capital spending doesn't arrive in smooth annual installments. A company might pour money into a new facility in one year, wreck that year's number, and generate strong cash for a decade afterward. Judging a business on a single year of free cash flow is how you talk yourself out of a good one. Look at five.
The trap: EBITDA is not cash flow
EBITDA strips out interest, taxes, depreciation, and amortization. That makes it useful for comparing the operating performance of companies with different debt loads and tax situations, which is a real purpose.
What it is not is cash. EBITDA ignores capital expenditures entirely, which means it quietly assumes that maintaining the business is free. For an asset-light software company, the distortion is small. For a manufacturer, an energy company, or a telecom that has to pour money into equipment every single year, the distortion is enormous, and it always runs in the flattering direction.
Treating EBITDA as though it were cash is one of the oldest mistakes in this business, and it's still being made in pitch decks this week. Use it as one input. Never as a substitute for the cash flow statement.
What to do with this
Pick a company you already own. Pull its most recent 10-K from the SEC's EDGAR database, which is free and takes about a minute to search. Find operating cash flow. Find capital expenditures. Subtract. Then divide the result by the company's market capitalization and compare that yield to the 10-year Treasury.
If the yield doesn't clear the Treasury, you now have a question worth asking about something you own. That's the whole point of the exercise. The number itself isn't the edge. Doing it consistently, across every name you consider, for years, is.
This is one number out of several dozen.
Book One works through the three financial statements, the ratios that separate businesses that compound from businesses that merely look cheap, and the growth-at-a-reasonable-price screen that keeps you from overpaying for either. The Financial Ratios Guide is the desk reference version, organized by category, with a case-study workbook built in.
Read the introduction to Book One free · See the Financial Ratios Guide