Free cash flow

Free cash flow is the cash generated from operations less the capital spending needed to keep operating. A company reporting $500m of operating cash flow that spent $200m on equipment and facilities produced $300m of free cash flow.

That figure is the cash available to pay dividends, buy back shares, repay debt or fund acquisitions, which is why it is the number most closely tied to what a shareholder eventually receives. Profit is measured under accounting rules; free cash flow is measured at the bank.

The definition is not standardised. Some analysts subtract only maintenance capital spending rather than all of it, on the argument that growth investment is discretionary, and the accounts do not split the two. Where a figure differs from another source, this is usually why.

Two mechanisms explain most of the gap, and they pull in opposite directions. Depreciation reduces profit without any cash leaving, so a capital-heavy company reports more cash flow than profit. Working capital runs the other way: a growing company funding more inventory and more unpaid customer invoices consumes cash that never appears as a cost.

The table takes two companies that each reported $100m of net income and follows the same lines down to free cash flow.

Neither pattern is good or bad in itself. The manufacturer converts profit into cash at a lower rate but is not consuming it; the distributor is profitable and still needs funding every quarter, which is sustainable while growth continues and turns sharply positive when it stops.

A single year of divergence is normal. A persistent and widening gap is the signal, and the direction matters.

Profit consistently above cash flow means earnings are being recognised faster than cash arrives. Sometimes that is a growing business funding working capital, and sometimes it is revenue recognised on terms that have not yet been collected. The receivables line separates the two.

Cash flow consistently above profit is the more common pattern at capital-heavy businesses and is usually depreciation on assets bought years ago. It is worth checking that capital spending is not running well below depreciation, which flatters cash flow now by under-investing in the assets that produce it.

Share-based pay is a real cost to existing owners because it dilutes them, but it is not a cash payment, so it is added back in the cash flow statement and increases reported free cash flow. At companies paying heavily in equity it can be a large share of the figure.

Investors disagree on whether to subtract it. The case for adding it back is that no cash left the business. The case against is that the company either issues shares, which transfers value from existing holders, or buys shares back to offset the issuance, which does consume cash and appears elsewhere.

Both readings are available here rather than one being chosen. Stock-based compensation is its own column beside free cash flow on the company pages, and the screener carries an SBC-adjusted free cash flow yield alongside the unadjusted one, so the same company can be ranked either way.

Free cash flow yield divides free cash flow by market capitalisation, so $300m of free cash flow at a $6bn market cap is a 5% yield. It is the cash-based counterpart to the earnings yield, and it is directly comparable with a bond yield in a way that a P/E is not.

Measured against enterprise value rather than market cap, the same figure answers a different question: what the whole business yields to everyone financing it, debt and equity together. That version is the more useful one when comparing companies with different borrowings.

A single year carries little information. Capital spending is lumpy, a new facility or a large acquisition distorts one period, and deferring investment flatters a year at the cost of the next few.

The shape across a decade is what matters: whether cash generation grows with revenue, whether it survives a downturn, and whether the capital spending that consumes it produces a return. Company pages show ten years for that reason, with the five and ten-year growth rates alongside.

Comparing a free cash flow figure from one source against another without checking the definition, since the treatment of capital spending, leases and stock-based compensation all vary.

Reading negative free cash flow as a problem in itself. A company growing quickly, or building a facility, produces the same negative number as one in difficulty, and the cash flow statement shows which.

Ignoring the gap between capital spending and depreciation. Spending well below depreciation for several years raises free cash flow now and defers the cost.

Applying it to banks and insurers, where borrowing is the raw material of the business and free cash flow as normally defined does not describe them.