Sometimes, the financial executive might be confused over the word “free” cash flow. Some might consider this merely as the net cash flow after deducting all cash flow /expenses.

Basically, the formula for free cash flow is :

Cash flows from Operations

minus

Cash flows from Investing

It measures a company’s net cash flows after deducing all paid expenditures required to maintain or expand the business which are the essentially interest payments and investments in “property, plant and equipment” (PP&E). Coined another way, it represents the cash that the business generates from operations after all investments have been made. They are free in the sense that they can be returned to its capital providers.

Free cash flow is often used by top management as this is not distorted by accounting for depreciation, write off, provisions. This free cash flow also considers any increase or decrease in working capital and finally payment for capital expenditures which is crucial for the expansion or survival of the company.

Incidentally, free cash flow is widely used for the valuation of a firm’s equity by cumulating the present value of all free cash flows.

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