The final cash measure is free cash-flows, one of the most important measures of economic performance in finance. You’ll see this number again and again when you look at how companies are valued or when companies discuss how they’re doing. The equation for calculating free cash-flows provides a measure of the amount of cash-flows truly unencumbered by the operations of a business. It’s the purest measure of cash and forms the basis of valuation. It removes the distorting effects of non-cash charges such as depreciation and amortization (like EBITDA), accounts for changes in working capital (like operating cash ‑ow), and finally, acknowledges that capital expenditures are required for growth and have been avoided so far. In short, free cash ‑ow isolates the cash that is truly free to be distributed or used however the company sees fit.
Free Cash Flow Equation:
Free Cash Flow (FCF) = EBIT – taxes + depreciation and amortization
+/- changes in working capital + Capital expenditures
You can visualize it by thinking about a simplified balance sheet. The net assets side of the balance sheet is divided between working capital (e.g., inventories and accounts receivables less accounts payable) and fixed assets (e.g., property, plant, and equipment), and the financing side of the balance sheet is divided between debt and equity.
This modified balance sheet now distinguishes between the operations (the left-hand side) and the capital providers’ (the right-hand side). The flows that operations generate that end up with the capital providers are the free cash-flows, which are calculated as follows.
