Calculating Free Cash Flow

How does a corporation make money? It makes money by operating business lines where it manufactures products or provides services. A company generates revenue by selling its products and services to another party. In generating revenue, a company incurs expenses—salaries, cost of goods sold (CGS), selling and general administrative expenses (SGA), research and development (R&D). The difference between operating revenue and operating expense is Operating Income or Net Operating Profit.

To produce revenue a firm not only incurs operating expenses, but it also must invest money in real estate, buildings and equipment, and in working capital to support its business activities. Also, the corporation must pay income taxes on its earnings.  The amount of cash that's left over after the payment of these investments and taxes is known as Free Cash Flow to the Firm (FCFF).

FCFF is an important measure to stockholders.  This is the cash that is left over after the payment of all cash expenses and operating investment required by the firm.  It is the hard cash that is available to pay the company's various claim holders, especially the good guys—the stockholders! The simple equation used to calculate FCFF is:

FCFF = NOP – Taxes – Net Investment – Net Change in Working Capital