FREE CASH FLOW

Free cash flow refers to cash that is available for distribution to creditors and
stockholders because it is not needed for working capital or fixed asset investments.
Perhaps the most important item that can be extracted from financial statements is the
actual cash flow of the firmin practice, there is some variation in exactly how free cash
flow is calculated.

Note! "et #ncome $ %ree &ash %low

&ash flows received from the firm's assets (i.e. operating activities)
* cash flow to creditors + cash flows to e,uity investors
Total Cash Flow of the Firm (&orporate %inance, -
th
ed. by .oss, /esterfield, 0 1affe)
Total cash flow of the firm * 2perating &ash %low 3 ad4ustments for capital spending
and additions to net working capital.
5
Formula!
2perating &ash %low
3 &apital 6pending
3 7 in "et /orking &apital
* 8otal &ash %low of the %irm
Staples (2007!
,9:;,<:=
3 ===,;5:
3 (35,:=-)
* -5>,;?>
Step "! &ash %lows from 2perations
Operati#$ cash flow measures the cash generated from operations (i.e. business
activities like the sale of goods and services). #t reflects tax payments, but does not count
capital spending or working capital re,uirements.
9

Formula!
@A#8
+ Bepreciation
3 8ax
* 2perating &ash %low
Staples (2007!
,=?,9-
+ 99?,5??
3 <?>,?>5
* ,9:;,<:=
Note!
2perating &ash %low * "2PC8 + depreciation
where, "et 2perating Profit Cfter 8ax ("2PC8) * @A#8 ( tax rate)
Step 2! &alculate &apital 6pending

6ource! &orporate %inance, -

th
edition by .oss, /esterfield 0 1affeD p. 5?395.
5
/hen firms are growing rapidly, spending on inventory and fixed assets may be higher than operating
cash flow causing this figure to be negative.
9
8his is the cash the firm is generating to pay operating costs (generally positive).

Capital spe#%i#$ measures changes in net operating long term assets (i.e. plant,
property, and e,uipment), the figure represents the ac,uisition of fixed assets minus the
sale of fixed assets.
Formula!
@nding PP@
3 Aeginning PP@
+ Bepreciation
* &apital 6pending
Staples (2007!
,?><,5
3 ,>=-,9?<
+ 99?,5??
* ===,;5:
Step &! &alculate the &hange in "et /orking &apital
<
Formula!
@nding 7 (&urrent Cssets
3 &urrent Eiabilities)
3 Aeginning 7 (&urrent Cssets
3 &urrent Eiabilities)
* 7 in "et /orking &apital
Staples (2007!
(<,<9,9:9 5,>--,9-9)
3 (<,<<,=<< 5,<>?,?;:)

* 35,:=-
Total cash flow of the firm * 2perating &ash %low 3 ad4ustments for capital spending
and additions to net working capital.
=
Formula!
2perating &ash %low
3 &apital 6pending
3 7 in "et /orking &apital
* 8otal &ash %low of the %irm
Staples (2007!
,9:;,<:=
3 ===,;5:
3 (35,:=-)
* -5>,;?>
8he author's note! C firm's total cash flow sometimes goes by a different name, free
cash flow.
:
Comments on Change in Working Capital
<
8he change in working capital is usually positive in a growing firm. 8he book uses a simple example
(that # follow here). #t is important to note that changes in working capital should be more closely
examined.
=
/hen firms are growing rapidly, spending on inventory and fixed assets may be higher than operating
cash flow causing this figure to be negative.
:
6ource! &orporate %inance, -
th
edition by .oss, /esterfield 0 1affeD p. 95.
5
/hile the formula discussed above offers a general guideline for calculating the cash
flow to the firm. #n practice several ad4ustments are typically made to the basic e,uation.
.emember %&% calculates the money that is available for distribution to all of the
company's investors, including creditors and stockholders.
Eet's look at the change in working capital a little more closely
6hort3term investments are not /&.
68 investments are typically a result of investment decisions made by
the treasurer.
68 investments sometimes represent capital that is parked for an
ac,uisition or ma4or capital investment.
Note! /hen you are uncertain about an item, ask yourself whether it is a natural
conse,uence of operations or a discretionary choice (i.e. a method of financing or
investment in a financial asset). #f it is a discretionary choice, it is "28 an operating
asset or liability.
>
Example! 6taples' 5;;> Aalance 6heet
C more accurate calculation for the change in "et /orking &apital for 6taples is shown
below.
>
6ource! %inancial Fanagement,5e by Arigham 0 @hrhardt, Chapter 3, pp. ?:3?>

X
X
X

9
2007 200'
&ash ,;>,:> ?>>,-55
CG. -:,?;= >5=,?5?
#nv. ,??,>< ,>;:,9>5
CGP 5,=->,5;: ,>=<,>-:
Cccruals
,55,;-< ,:==,99>
(p%ate%! &alculate the &hange in "et /orking &apital
Formula!
@nding 7 (&ash + CG. + #nv.
3 CGP +Cccruals)
3 Aeginning 7 (&ash + CG. + #nv.
3 CGP +Cccruals)
* 7 in "et /orking &apital
Staples (2007!
,55,;-<
3 ,:==,99>

* 3<<9,5=9
(p%ate%! %ree &ash %low
Formula!
2perating &ash %low
3 &apital 6pending
3 7 in "et /orking &apital
* 8otal &ash %low of the %irm
Staples (2007!
,9:;,<:=
3 ===,;5:
3 (3<<9,5=9)
* ,5<-,:?5
8his is consistent with the formula in %inancial Fanagement, p. ; (shown below)
<