Cash flow is the lifeblood of any business—money is what flows through the veins of your company and keeps it alive. Your business’s free cash flow—i.e., your “leftover” money—is an indicator of your company’s financial health. It shows how much money your company has to pay its balances and potentially invest back into company growth.
Free cash flow yield takes that one step further and shows how much cash flow can be paid to a company’s investors per share that they own.
What is free cash flow?
Free cash flow (FCF) is the money a company has left over to repay its debts, pay out dividends to stakeholders, reinvest in itself, or save once it’s paid off all of its expenses. Free cash flow is a subset of cash flow, a broader term used to describe the money entering and leaving a company’s bank accounts.
FCF is reported on thebalance sheet, a record of the funds flowing in and out of your company over a given period.
How to calculate free cash flow
To calculate your business’s FCF, take the total cash generated from your operations and subtract your capital expenditures (i.e., investments in long-term assets, like property, equipment, or patents).
Free cash flow = cash from business operations - capital expenditures
Apositive FCFmeans that a company generates cash, which, if high enough, could be reinvested in new products, marketing initiatives, or employees. It can also mean the company is in good financial shape and can afford to pay dividends to shareholders.
A negative FCF may indicate a company is struggling financially and may not have enough cash to invest in new products or employees. It may also show the company isn’t generating enough revenue to cover its capital expenses
A negative FCF ratio could be a sign of trouble and may warrant further investigation by its owners.
What is free cash flow yield?
Free cash flow yield describes how much free cash flow is available in relation to a company’s market capitalization—that is, relative to the company’s stock market value. Free cash flow yield is mainly used to calculate how much cash is paid out to stakeholders through dividends and interest.
Here is the free cash flow yield ratio formula:
Free Cash Flow Yield = Free Cash Flow Per Share / Market Price Per Share
Free cash flow yield is important because it shows how much money a company has available to pay dividends to shareholders.
Levered vs. unlevered free cash flow yields
Investors often use two types of free cash flow yields to assess how much money they can expect to gain from an investment: levered and unlevered.
Levered free cash flow yield
A levered free cash flow yield is the amount of money your business has after it’s paid off all of its expenses and obligations.
Levered free cash flow yield is vital because it not only points to your company’s financial health but is also used to calculate how much funds are available to pay out to equity investors.
The formula for calculating levered free cash flow yield includes earnings before interest, taxes, depreciation, and amortization (EBITDA), as well as capital expenditures (CAPEX)—the money your company uses to buy fixed assets—and change in net working capital. The formula is:
Levered Free Cash Flow Yield = EBITDA − Net Working Capital − CAPEX − Mandatory Debt Payments
Unlevered free cash flow yield
Anunlevered free cash flowyield is the amount of money your business has before it’s paid off all of its financial obligations. A high unlevered free cash flow yield means a company has a lot of cash available to reinvest in its business or pay out to equity holders.
The formula for unlevered free cash flow yield includes earnings before interest, taxes, depreciation, and amortization (EBITDA), as well as capital expenditures (CAPEX). The formula is:
Unlevered Free Cash Flow Yield = EBITDA − CAPEX − Working Capital − Taxes
Levered free cash flow yields are typically higher than unlevered ones because they consider the impact of debt on a company’s finances. When a company carries large debts, its levered free cash flow is lower than its unlevered free cash flow because interest payments on the debt reduce the amount of money available for other purposes.
Free cash flow vs. earnings
Earnings, also known as net income, are calculated as a company’s total revenue minus its total expenses. Free cash flow takes this assessment further by subtracting capital expenditures from operating cash flow, the cash generated by a business’s everyday operations.
Capital expenditures are investments in a company’s long-term assets, such as property, equipment, or patents. These are not recurring expenses, like salaries or rent payments, and should be subtracted fromoperating cash flowfor a more accurate picture of a company's financial health.
Free cash flow yield FAQ
What does a high cash flow yield mean?
A high cash flow yield means a company is generating a lot of cash, which it can use to pay shareholders or expand. This ratio can be used to measure how efficient the company is at generating cash from its operations.
How do you calculate cash flow yield ratio?
To calculate the cash flow yield ratio, divide the company's free cash flow by its market capitalization:
Free Cash Flow Yield = Free Cash Flow Per Share / Market Price Per Share
How do you calculate levered free cash flow?
Levered Free Cash Flow = Net Income + Depreciation + Amortization - Change in Net Working Capital - Capital Expenditures - Mandatory Debt Payments
How do you calculate unlevered free cash flow?
Unlevered Free Cash Flow = Operating Income × (1 - Tax Rate) + Depreciation + Amortization − Change in Net Working Capital − Capital Expenditures
What is the FCF ratio?
The FCF ratio measures how much free cash flow a company generates compared to its total market value—a helpful way to measure a company’s overall financial health.