Form Follows Function: The Appropriate Definition of Free Cash Flow

Abstract

Many financial analysts and investors believe that measures of cash flow are extremely useful when analyzing the financial health and prospects of a company. In recent years, a measure called “free cash flow” has become widely used. However, many different definitions and ways to calculate free cash flow are currently being used. Rather than relying on these somewhat arbitrary definitions, the appropriate definition of free cash flow should be determined by the measure’s intended use. Perhaps the most important use of free cash flow measures is in estimating the value of a company. Therefore, we suggest that the definition of free cash flow that fits this use is the most appropriate definition. In addition, the building blocks used in this definition also provide the best measure of a firm’s annual operating performance, the return on invested capital. We illustrate alternative approaches to proper free cash flow calculation. And, we show how free cash flow can be reconciled to the net “cash flow provided (used) by operating activities” as found on the statement of cash flows, and explain why it may be important to do so.

Keywords: Free Cash Flow (FCF), Valuation, Statement of Cash Flows

JEL Classification: G30, G31