How free cash flow works
Profit is an opinion; cash is a fact. Free cash flow starts from what the business earned and strips the accounting back out: add back depreciation (a real expense on paper, but no cash left the building), subtract the cash that got tied up in inventory and unpaid invoices, and subtract what was spent on new plant and equipment. What survives is the cash the firm could actually hand to its investors. The full build starts from EBIT so the result is unpolluted by financing choices — that is FCFF — and then a short financing bridge (after-tax interest out, net borrowing in) converts it into FCFE, the cash that belongs to shareholders alone.
The three formulas
FCF = Operating cash flow − CapEx
FCFF = EBIT × (1 − t) + D&A − ΔNWC − CapEx
FCFE = FCFF − Interest × (1 − t) + Net borrowing
where t is the tax rate, D&A is depreciation and amortization, ΔNWC is the increase in net working capital (negative when working capital is released), and net borrowingis new debt raised minus principal repaid. EBIT × (1 − t) is NOPAT — operating profit taxed as if the firm had no debt — which is what keeps FCFF independent of the capital structure.
Worked example
A company earns $1,500M of EBIT at a 21% tax rate, adds back $400M of D&A, ties up $150M in working capital, spends $500M on capex, pays $200M of interest, and raises $100M of net new debt (all figures in $ millions). Here is the bridge from EBIT to FCFF to FCFE:
| Step | Amount |
|---|---|
| EBIT (operating income)operating income from the income statement, before any financing effects | $1,500M |
| Taxes on EBIT at 21%$1,500M × 21% — taxed as if the firm carried no debt at all | −$315M |
| = NOPAT — net operating profit after taxesEBIT × (1 − 21%) — the unlevered after-tax operating profit | $1,185M |
| Depreciation & amortizationnon-cash charge added back: it reduced EBIT, but no cash left the firm | +$400M |
| Change in net working capitalworking capital grew, tying cash up in receivables and inventory | −$150M |
| Capital expenditurescash reinvested in property, plant, and equipment | −$500M |
| = FCFF — free cash flow to the firmcash available to all capital providers — pair with the WACC | $935M |
| After-tax interest expense$200M × (1 − 21%) — what lenders take, net of the tax shield | −$158M |
| Net borrowingnew debt raised minus principal repaid — cash equity holders gain | +$100M |
| = FCFE — free cash flow to equitycash available to shareholders — pair with the cost of equity | $877M |
Computed with this calculator's default settings — open the tool above and you'll see the same bridge, then swap in any company's filings.
Match the cash flow to the discount rate
The reason the FCFF/FCFE distinction matters is valuation. FCFF is the cash available to all capital providers, so in a discounted cash flow model it must be discounted at the blended required return of debt and equity — the WACC — and the present value you get is enterprise value. FCFE belongs to shareholders only, so it is discounted at the cost of equity, and the result is equity value directly. Pairing FCFF with the cost of equity, or FCFE with the WACC, is the classic DCF error — Aswath Damodaran's Investment Valuation hammers on this matching principle precisely because mixing the two silently double-counts or drops the cash flows that belong to lenders.
Put the pieces together: feed your cash flow forecast into theDCF calculatorto turn it into a present value, build the matching discount rate with theWACC calculator, and use theenterprise value calculatorto see the net-debt bridge that connects the enterprise value an FCFF model produces to the equity value an FCFE model produces.
Frequently asked questions
What is free cash flow?
Free cash flow is the cash a business generates after paying for the investment needed to keep it running — money genuinely available to the people who financed it. The catch is that the phrase names at least three different measures. The simple version is operating cash flow minus capital expenditures, read straight off the cash flow statement. FCFF (free cash flow to the firm) rebuilds the number from EBIT to show the cash available to all capital providers, and FCFE (free cash flow to equity) narrows it to what is left for shareholders. When two analysts quote different "FCF" figures for the same company, they are usually computing different definitions, not making an arithmetic error.
What is the difference between FCFF and FCFE?
FCFF is the cash the operating business generates for every capital provider — lenders and shareholders alike — so it is computed before any financing flows, starting from after-tax operating profit (NOPAT). FCFE is what remains for shareholders specifically: take FCFF, remove the after-tax interest that lenders collect, and add net borrowing, because newly raised debt is cash equity holders can deploy. FCFF is capital-structure-neutral — two identical businesses with different debt loads report the same FCFF — while FCFE moves whenever leverage changes. That is exactly why FCFF values the whole enterprise and FCFE values the equity directly.
Why subtract the change in net working capital?
Accrual accounting books revenue when it is earned, not when the cash arrives. If receivables and inventory grow faster than payables, the company has recorded profit it has not yet collected — the cash is tied up in working capital. Subtracting the increase in net working capital converts accrual profit back into cash. The sign flips symmetrically: when working capital shrinks (customers pay faster, inventory runs down), cash is released and the change adds to free cash flow. Enter a negative change in this calculator to model that release.
Why is free cash flow different from net income?
Net income is an accrual measure: it deducts non-cash charges like depreciation, ignores capital expenditures entirely (they hit the income statement only gradually, as future depreciation), and recognizes revenue before cash is collected. Free cash flow reverses each of those choices — add back D&A, subtract capex when the cash is actually spent, and adjust for working capital. The two can tell very different stories: a company can report healthy profits while burning cash on inventory and equipment, or report accounting losses while gushing cash. Over a long horizon they converge, but in any given year cash flow is the harder number to flatter.
Which free cash flow should I use in a DCF?
Match the cash flow to the discount rate. FCFF belongs to all capital providers, so discount it at the weighted average cost of capital — the blended required return of debt and equity — and you get enterprise value; subtract net debt to reach equity value. FCFE belongs to shareholders only, so discount it at the cost of equity and you get equity value directly. Crossing the wires — FCFF at the cost of equity, or FCFE at the WACC — is the classic DCF error, and it double-counts or drops the cash flows to lenders. Either pairing, done consistently, should give the same answer.
Sources
The official figures this page quotes are drawn from the primary sources above — check them (or a qualified professional) before relying on a result.
Disclaimer: This calculator is foreducation and illustration only. Real filings require judgment calls this tool does not make — which working-capital items to include, how to treat leases and stock-based compensation, and what tax rate is truly marginal. Its output is a textbook calculation, not a valuation opinion, and nothing here is investment, tax, or trading advice.