Free cash flow

Free cash flow is the cash remaining after a company has paid for everything required to maintain and grow its operations. It is often considered a more reliable indicator of financial health than net income because it measures actual cash generation rather than accounting profit.

Net income can be distorted by non-cash items like depreciation, stock-based compensation, and accrual timing differences. A company can report strong net income while burning cash, or report a loss while generating significant cash. FCF cuts through these accounting abstractions to show how much cash the business actually produces.

For investors, FCF represents the economic output of the business that is available for distribution or reinvestment. A company with strong, growing FCF has the financial flexibility to pursue opportunities, weather downturns, and return capital to shareholders. A company with negative FCF must rely on external financing to fund its operations, regardless of what the income statement shows. For pre-profit companies, cash runway and burn rate provide complementary views of cash sustainability.

The standard formula starts with operating cash flow from the cash flow statement:

FCF = Operating Cash Flow - Capital Expenditures

A more detailed calculation builds from net income:

FCF = Net Income + Depreciation & Amortisation + Changes in Working Capital - Capital Expenditures

FCF margin expresses free cash flow as a percentage of revenue:

FCF Margin = FCF / Revenue x 100

For SaaS companies, capital expenditures are typically small (mainly capitalised software development), so FCF is often close to operating cash flow. The key adjustments are usually working capital changes (driven by the timing of customer payments and deferred revenue) and stock-based compensation (which is a non-cash expense that inflates operating cash flow).

The tree shows that FCF is influenced by profitability (net income), accounting policies (non-cash adjustments), operational efficiency (working capital management), and investment decisions (capex). For SaaS companies, the most impactful levers are typically net income and deferred revenue changes. Growing deferred revenue (from annual prepayments) improves FCF even when it creates an accounting liability.

1. 1

   Improve operating margins

   Higher profitability directly increases operating cash flow. Revenue growth with operating leverage is the most sustainable path.

2. 2

   Optimise working capital

   Collect receivables faster, manage inventory tighter, and negotiate longer payable terms. Each improvement releases cash.

3. 3

   Encourage annual prepayment

   Annual and multi-year prepayments from customers boost deferred revenue and bring cash in earlier, improving FCF.

4. 4

   Discipline capital expenditure

   Evaluate capex investments rigorously. Prefer opex models (cloud services) over capex models (owned infrastructure) where the economics are favourable.

1. 1

   Ignoring stock-based compensation

   SBC is a real economic cost even though it is non-cash. FCF that includes SBC as an add-back overstates the cash available to shareholders because it ignores dilution.

2. 2

   Confusing FCF with EBITDA

   EBITDA excludes capex and working capital changes. A company with strong EBITDA but high capex may have weak or negative FCF.

3. 3

   Not adjusting for one-time items

   Large one-time payments (litigation settlements, restructuring costs) can distort FCF in a given period. Look at normalised or recurring FCF for trend analysis.