What Does Free Cash Flow (FCF) Mean?
Free cash flow (FCF) is a financial metric that includes cash flow generated from operations, minus annual capital expenditures required to sustain the business (maintenance capex). It is a key metric used by buyers to evaluate a business. Free cash flow is sometimes calculated on an after tax basis. However, most buyers calculate free cash flow before tax, because their tax structure may be different than the target company for sale.
Divestopedia Explains Free Cash Flow (FCF)
While free cash flow theoretically excludes changes in net working capital, these changes can greatly affect the real cash generated by a business. Free cash flow is not only impacted by company's revenue and profitability, but also by how the balance sheet is managed. If the business does not manage its net working capital assertively or is undisciplined with capital expenditures, then free cash flow can be considerably lower than net earnings. Buyers often review the quality of earnings, which is essentially the difference between reported earnings and the free cash flow of the business.
Some buyers and sellers use EBITDA and FCF synonymously, but technically this is incorrect. EBITDA doesn't take into account the requirement for sustaining capital expenditures or changes in working capital. Both the investment in working capital and sustaining capex is a real cash outflow that impacts the business going forward, and should be considered by buyers. This doesn't mean that EBITDA isn't a useful metric for valuing business, but rather that other metrics such as EBIT and free cash flow may be more useful to determine what the actual future return on the investment will be.