No. The cash flow is how much cash the business’ operations generated. The cash and cash equivalents, though an asset of the business, were not necessarily generated by the business’ operations in that particular quarter or year.

Cash and cash equivalents can come into play when valuing a company, but not when calculating free cash flow or owner earnings.

Shouldnt we add Cash and Cash equiv. in above formula?

Yours is the original formula I posted in my comment. When it comes down to it, you can use either one – so long as you are consistent. Using the formula I posted gives you the raw FCF – without any corrections for stock options, tax benefits received, or other non-cash charges. It is essentially the FCF if the company was stripped down to its bare operations.

Then again, how likely is it that management will give up the stock-based compensation? Your formula, and the one I had originally posted, gives us the “Silent Partner Earnings” – the free cash flow we little guys have to accept because we have no say in the operations.

In Calculating The Value Of A Business – Part II (coming tomorrow), I am going to discuss the two methods and talk about which one I like. Rest assured, I generally prefer and use the one you mention – the “Silent Partner Earnings.”

Good article, but I think a better (and easier) solution to obtaining FCF from a cash flow statement is to take “Cash flow from Operations” and subtract “Investments in Plant Property & Equipment”. You will also see this listed as CapEx for many firms (to use the example of JNJ on Morningstar).

A firm that is growing over time will need to invest in working capital (inventory, accounts receivable,etc.). Taking Net Income and adding back depreciation misses this.

I think you’ll find that Morningstar also calculates FCF in this manner.

It would be of great help if you posted an article on how to treat variations in free cash flows e.g of you have a company that is generating huge cash but is also reinvesting heavily e.g Walmart; FCF will be low for recent years but future FCF’s will be higher as the investments pay offs or where recent free cash flows are much lower than history e.g IBM

There are two ways to determine Free Cash Flow:

1) You can find it on (a few) financial websites. I like Morningstar because they already calculate the Free Cash Flow for you. Look up a company and head to their “10-Year Cash Flows” section under “Fundamentals.” Free Cash Flow is listed at the bottom.

2) You can calculate it by looking at the Statement of Cash Flows for a business – one of the three financial statements (the other two being the Balance Sheet and the Income Statement). On the Statement of Cash Flows, you can calculate the Free Cash Flow by taking the Net Income plus Depreciation and Amortization minus Net Additions (Subtractions) of Plant, Property, & Equipment.^*

In any event, that Free Cash Flow calculation will tell you if the business can grow or survive on its operations alone or if it has to rely on other sources of cash to pay its bills.

These numbers come right from the company’s bank statements. Earnings are easily manipulated. Cash is very hard to fake.

Hope that helps!

Edit: July 18, 2007: Sorry folks, I had given you the wrong calculation. I changed it (above) to accurately reflect Free Cash Flow (aka, Owner Earnings). I use the above formula; however, I had typed it wrong prior to this edit. Sorry for any confusion!