Free Cash Flow (FCF)

Key takeaways

FCF measures cash actually available — not accounting profit. Net income includes non-cash charges (D&A) and excludes capex; FCF strips both.
Two definitions: FCFF (unlevered, before debt service) is used in DCF; FCFE (levered, after debt service) is what equity holders actually receive.
The capex distinction matters — maintenance capex keeps the business running, growth capex expands it. Pure FCF mixes both; "owner earnings" (Buffett's term) backs out growth capex.
Working capital deltas can mask or amplify FCF. A growing business consumes working capital (use of cash); a shrinking business releases it.
Companies that report negative GAAP earnings can still generate positive FCF, and vice versa. The two diverge most in capital-intensive or fast-growing businesses.

Two definitions, one purpose

Unlevered Free Cash Flow (FCFF)

The cash the business generates before any debt service. Used in DCF because the discount rate (WACC) reflects both debt and equity providers, so FCF must reflect what's available to both.

FCFF = EBIT × (1 − t) + D&A − CapEx − ΔNWC

EBIT × (1 − t) is also called NOPAT (net operating profit after tax). The D&A add-back is non-cash. CapEx is the cash invested in long-lived assets. ΔNWC captures cash tied up in (or released from) working capital.

Levered Free Cash Flow (FCFE)

The cash available to equity holders after creditors are paid. Used in equity-side DCFs (e.g., for banks, where FCFF doesn't fit), or to gauge how much can be paid out as dividends or used for buybacks.

FCFE = Net Income + D&A − CapEx − ΔNWC + Net Borrowing

Net Borrowing is debt issued minus debt repaid — it adjusts for the financing side. FCFE can be negative even when FCFF is positive if the company is repaying debt aggressively.

Building FCF from financial statements

Most analysts work backward from the cash flow statement rather than from EBIT, since the cash flow statement already reconciles non-cash items:

FCFF = Cash from Operations − CapEx + Interest × (1 − t)
FCFE = Cash from Operations − CapEx

The interest add-back to FCFF reverses the tax shield (since FCFF is pre-financing). For FCFE, the interest expense is already subtracted in net income, so cash from ops − capex is sufficient.

Worked example

A company reports the following:

EBIT: $400M
Tax rate: 25%
D&A: $80M
CapEx: $100M
Increase in working capital: $20M
Net Income: $250M
Net Borrowing: $50M

Metric	Calculation	Value ($M)
NOPAT	$400 × (1 − 0.25)	300
+ D&A		80
− CapEx		(100)
− ΔNWC		(20)
FCFF		260
Net Income		250
+ D&A − CapEx − ΔNWC		(40)
+ Net Borrowing		50
FCFE		260

FCFF and FCFE happen to match here because the net borrowing offsets the interest tax shield differential. They typically diverge.

Maintenance vs growth capex

Standard FCF lumps all capex together. For a high-growth business, much of the capex is funding expansion, not just maintaining existing operations. Owner earnings (Warren Buffett's framing) backs out growth capex:

Owner Earnings = Net Income + D&A − Maintenance CapEx

Maintenance capex is hard to estimate from outside — companies don't typically disclose the split. Approximations: depreciation expense as a proxy (assumes maintenance capex equals depreciation), or industry benchmarks (typically 30–60% of total capex for industrial businesses). For DCF purposes, total capex is the safer assumption; for assessing "true" earnings power, owner earnings is the more honest read.

Working capital — the FCF rollercoaster

Working capital changes are the most volatile FCF component. Patterns:

Growing business: AR and inventory grow with revenue; working capital is a use of cash; FCF is suppressed below earnings.
Shrinking business: working capital releases cash; FCF can exceed earnings even as the business deteriorates.
Seasonal business: WC swings widely intra-year; smooth using LTM or rolling-4-quarter measures.
Negative WC business (subscription, prepaid services): customers pay before delivery; growth releases cash; FCF runs ahead of earnings.

Common FCF errors

Confusing operating cash flow with FCF. OCF is on the cash flow statement; FCF subtracts capex from OCF. Many investor presentations show OCF and call it FCF.
Ignoring working capital. A company growing 20% with high DSO can show positive earnings and negative FCF.
Using book D&A as capex proxy. Acceptable for steady-state mature businesses; wrong for growth companies where capex runs above D&A.
Wrong tax rate on interest add-back (FCFF). Use the marginal tax rate, not the effective rate.
Stock-based compensation handling. SBC is non-cash on the income statement (added back to OCF), but it is a real economic cost (dilutes shareholders). Many practitioners subtract SBC from FCF for valuation purposes.

How Smalt AI builds it

Smalt AI's DCF and three-statement models compute FCFF as a derived line from EBIT, with each component traceable back to the income statement, balance sheet, and capex schedule. Working capital changes flow from DSO/DIO/DPO assumptions on the working-capital tab. The model also derives FCFE and shows a reconciliation between GAAP earnings and FCF, so the divergence is auditable. Sensitivity tables include FCF growth × discount rate where appropriate.