Key takeaways
What this article covers, in order:
- The basic cash flow equation first
- Equation 1: simple free cash flow
- Equation 2: free cash flow to the firm (FCFF)
- Equation 3: free cash flow to equity (FCFE)
- Worked example: Alder Precision
- Maintenance versus growth capital spending
The basic free cash flow equation is free cash flow = cash flow from operations − capital expenditure. It tells you how much cash the business generated after paying to maintain and expand its fixed assets: the cash that is genuinely free to repay debt, pay owners, or build a reserve.
Analysts also use two more precise versions: free cash flow to the firm (FCFF), which is the cash available to all lenders and shareholders, and free cash flow to equity (FCFE), which is what is left for shareholders alone. This guide gives each equation, works all three through one example, and explains which to use when.
The basic cash flow equation first
Every cash flow statement rests on one identity:
Net change in cash = cash from operating activities + cash from investing activities + cash from financing activities
Free cash flow takes a slice of that. It keeps operating cash flow, takes out only the capital-spending part of investing, and ignores financing completely, so it shows what the business produces before any decisions about borrowing or paying owners.
Equation 1: simple free cash flow
FCF = cash flow from operations − capital expenditure
- Cash flow from operations comes straight from the operating section of the cash flow statement.
- Capital expenditure is the cash paid for property, plant and equipment (and usually capitalised software), shown in investing activities. It is not depreciation, which is a non-cash expense in the income statement.
If you only have an income statement and balance sheets, the same thing can be built up as net income + non-cash expenses − increase in working capital − capital expenditure.
This is the version most owners and lenders use. It is quick, it comes directly from published figures, and it answers a practical question: after keeping the business running and growing, how much cash did we have left?
Equation 2: free cash flow to the firm (FCFF)
FCFF measures cash available to everyone who has funded the business, lenders and shareholders together. Because lenders are included, interest is treated as a distribution of that cash, not a cost of producing it. Two common forms:
FCFF = CFO + interest paid × (1 − tax rate) − capital expenditure
FCFF = EBIT × (1 − tax rate) + depreciation and amortisation − capital expenditure − increase in working capital
The add-back is after tax because interest reduced the tax bill. Removing the interest also removes that tax saving.
An important classification point: the first form assumes interest paid was deducted inside CFO, which is always the case under US GAAP. Under IFRS, many companies classify interest paid in financing, and from annual periods beginning on or after 1 January 2027 most non-financial IFRS reporters must. If interest paid is already outside CFO, do not add it back again.
FCFF is the cash flow used in enterprise valuation models, because it does not depend on how the business is financed.
Equation 3: free cash flow to equity (FCFE)
FCFE is what is left for shareholders after lenders have been paid and new borrowing has been taken into account:
FCFE = CFO − capital expenditure + net borrowing
Net borrowing is new debt raised minus debt principal repaid. This version assumes interest was deducted in CFO. FCFE is the measure that most closely tracks what a company could pay out in dividends or buybacks without running down its cash.
Worked example: Alder Precision
Alder Precision is a CNC machining company that makes components for agricultural equipment. Its figures for the year:
- Operating profit (EBIT): $1,200,000
- Interest expense, all paid in cash: $200,000
- Profit before tax: $1,000,000
- Income tax at 25%, all paid in cash: $250,000
- Net income: $750,000
- Depreciation: $400,000
- Increase in working capital (more stock and receivables): $150,000
- Capital expenditure on two new five-axis machines and tooling: $700,000
- New equipment loan drawn: $300,000; loan principal repaid: $100,000
Alder reports under US GAAP, so interest paid sits inside operating cash flow.
Step 1: cash flow from operations
CFO = 750,000 + 400,000 − 150,000 = $1,000,000
Step 2: simple FCF
FCF = 1,000,000 − 700,000 = $300,000
Step 3: FCFF from CFO
After-tax interest = 200,000 × (1 − 0.25) = $150,000
FCFF = 1,000,000 + 150,000 − 700,000 = $450,000
Step 4: FCFF from EBIT, as a cross-check
EBIT × (1 − 0.25) = $900,000
FCFF = 900,000 + 400,000 − 700,000 − 150,000 = $450,000. The two routes agree, which is a good sign the inputs are consistent.
Step 5: FCFE
Net borrowing = 300,000 − 100,000 = $200,000
FCFE = 1,000,000 − 700,000 + 200,000 = $500,000
You can also get there from FCFF: 450,000 − 150,000 + 200,000 = $500,000.
What the three numbers say
- $300,000 simple FCF: after paying for its new machines, Alder's operations left $300,000 of cash. That is 40% of net income, a lower conversion than usual because of the heavy capital spending this year.
- $450,000 FCFF: the cash available to lenders and shareholders combined, before interest.
- $500,000 FCFE: higher than simple FCF only because Alder borrowed $200,000 more than it repaid. That part is borrowed money, not cash the business earned, so a dividend sized to FCFE would partly be funded by the new loan.
Maintenance versus growth capital spending
Not all capital expenditure is equal. Replacing worn machines keeps the business where it is; buying extra machines grows it. Some owners estimate the maintenance share and calculate a second figure, operating cash flow minus maintenance capex only, to see what the business would produce if it stopped expanding. The split is not reported in financial statements, so it is an estimate. Depreciation is often used as a rough proxy. If Alder judged that about $350,000 of its spending was replacement, its free cash flow before growth spending would be about $650,000.
When free cash flow is negative
Negative free cash flow in a single year is not automatically a problem. A business buying a large asset, opening a new site or growing fast will often show it. What matters is whether the spending earns a return later and whether the business has the funding to bridge the gap. Several years of negative free cash flow with flat sales is a different story.
Common mistakes with the free cash flow equation
- Using depreciation instead of capital expenditure. Depreciation spreads past spending over time; capex is the cash actually paid this year.
- Adding back interest in simple FCF. Simple FCF is after interest. Only FCFF adds it back.
- Adding back interest twice under IFRS. If interest paid is already in financing, CFO never deducted it.
- Treating new borrowing as free cash. It inflates FCFE but has to be repaid.
- Missing capital spending financed off the cash line. Equipment acquired through financing arrangements may never appear as capex in investing activities, which can flatter FCF. Read the notes on leases and non-cash transactions.
- Comparing companies on different frameworks without checking where interest and dividends are classified.
hellobooks< / a > -helps">How HelloBooks helps
HelloBooks produces the cash flow statement by the direct or indirect method, so operating cash flow and the capital spending line are available from your books each period. The fixed assets register records each asset purchase and its depreciation separately, which keeps capex and depreciation from being confused, and tracking by class, location or project lets you see which part of the business is consuming the investment. The CFO dashboard and budget vs actual reports help you plan capital spending against expected cash. Your accountant can review the figures before you use them for a lending or valuation discussion.
