Free Cash Flow

What is free cash flow?

Free cash flow is the cash surplus that remains for a company from its ongoing business after deducting investments. It is available for payments to equity and debt providers, for repaying debt or for further growth. In its simplest form: operating cash flow, that is, the balance of receipts and payments from ongoing business, minus payments for investments.

The German Commercial Code (Handelsgesetzbuch, HGB) does not know the term, and there is no binding definition. It matters in company valuation, in purchase price negotiations, in credit assessment and in the financial model. Because the delimitation is handled differently in the details, valuation reports, financing documents and purchase agreements state which items are included.

Calculating free cash flow: formulas

From the cash flow statement

Formula: Free cash flow = cash flow from operating activities - payments for property, plant and equipment and intangible assets + receipts from their disposal

The values come from the cash flow statement. Company acquisitions and financial assets are generally left out, because they do not belong to ongoing business. It has to be checked where the interest paid is shown. Depending on the classification, operating cash flow already includes it or not, and the value determined in this way is then after or before interest.

From operating profit

For valuation purposes, free cash flow is usually derived from operating profit (EBIT, earnings before interest and taxes). Income taxes are deducted from EBIT as they would arise if the company were financed entirely with equity. The result is the cash flow that belongs to all capital providers together, regardless of how the company is financed.

Formula: Unlevered free cash flow = EBIT × (1 - tax rate) + depreciation and amortisation - investments - increase in working capital

Unlevered and levered free cash flow

• Unlevered free cash flow (free cash flow to the firm, free cash flow to all capital providers): the cash flow before interest and loan repayments that belongs to equity and debt providers together. Discounted at the weighted average cost of capital (WACC, the weighted mean of the cost of equity and the cost of debt), it gives the company value (enterprise value).
• Levered free cash flow (free cash flow to equity, free cash flow to the owners): the cash flow that remains solely for the owners after interest and after loan repayments less newly taken-out loans. Interest is included after tax, because it reduces the tax burden. It is discounted at the cost of equity.

With the same assumptions, both routes lead to the same value of equity. On the first route, the equity value is determined by deducting financial liabilities from the company value and adding liquid funds. Which interest rate belongs to which cash flow is explained in the entry on the discount rate.

Free cash flow in company valuation

DCF valuation determines the company value as the present value of future free cash flows. For a detailed planning period of often three to five years, the cash flows are planned individually. For the time after that, a terminal value is formed from a sustainable free cash flow and a long-term growth rate. In practice, a large part of the total value often falls on this terminal value, which is why the assumptions on sustainable free cash flow have to be justified especially carefully.

To be distinguished from the DCF method is the income capitalisation approach (Ertragswertverfahren). The valuation standard IDW S 1 of the Institute of Public Auditors in Germany (IDW) permits both methods, and the income capitalisation approach is widespread in Germany. It does not discount free cash flow but the financial surpluses that flow to the company's owners. The interest rate is based on the return of an alternative investment in company shares. With the same assumptions, both methods theoretically lead to the same result. For valuations under company law, such as compensation payments, the income capitalisation approach predominates in practice; in transactions, DCF methods and multiples are widespread.

Valuations using multiples such as the EBITDA multiple also rest indirectly on free cash flow. Two companies with the same EBITDA are worth different amounts if one of them has to finance high investments and growing working capital. The ratio of free cash flow to EBITDA (free cash flow conversion) therefore often explains why multiples within an industry differ. The term is not used uniformly; in some cases, operating cash flow before investments is also set in relation to EBITDA.

Significance in financing and company acquisitions

Growth companies generally have negative free cash flow, because they invest in personnel, product and sales. Investors therefore examine less today's value than the path to positive free cash flow and the question of whether the capital deployed leads to higher cash flows. Lenders use free cash flow to measure debt service capacity, that is, whether interest and loan repayments can be paid out of the business.

In company acquisitions, acquirers normalise the free cash flow of the past and of the plan. Three points are regularly at the centre:

• Maintenance and expansion investments: For the question of what the existing business earns on a lasting basis, only the investments necessary for maintenance count. Expansion investments belong to growth planning.
• Capitalised development costs: Under Section 248(2) HGB, internally generated intangible fixed assets, such as self-developed software, may under certain conditions be included in the balance sheet as an asset (capitalised). Capitalisation improves EBITDA but not free cash flow, because the payments then appear as an investment.
• Leasing: Under the HGB, lease payments are usually an operating expense; under IFRS 16, the repayment portion is allocated to financing activities. Without adjustment, free cash flows from HGB and IFRS financial statements are not comparable.

Worked example: calculating free cash flow from EBITDA

An industrial services provider plans EBITDA of EUR 2.0 million and depreciation and amortisation of EUR 400,000 for the next year. Investments amount to EUR 600,000, and working capital rises by EUR 300,000 because of growth. For simplicity, an income tax rate of 30% is applied. For a GmbH, as of 2026, this corresponds roughly to the burden from 15% corporation tax, the solidarity surcharge and trade tax at a municipal multiplier of 400%. For plan years from 2028, the decided reduction of corporation tax by one percentage point a year down to 10% in 2032 has to be taken into account.

• EBIT: 2,000,000 minus 400,000 = EUR 1,600,000
• Taxes on EBIT: 1,600,000 × 30% = EUR 480,000
• Result after tax assuming pure equity financing: 1,600,000 minus 480,000 = EUR 1,120,000
• Plus depreciation and amortisation: 1,120,000 + 400,000 = EUR 1,520,000
• Less investments and increase in working capital: 1,520,000 minus 600,000 minus 300,000 = EUR 620,000 unlevered free cash flow
• Free cash flow conversion: 620,000 / 2,000,000 = 31%
• Interest of EUR 100,000 after tax benefit: 100,000 × (1 minus 30%) = EUR 70,000
• Levered free cash flow with EUR 150,000 of loan repayment: 620,000 minus 70,000 minus 150,000 = EUR 400,000

From EUR 2.0 million of EBITDA, EUR 620,000 of freely available funds remain for all capital providers and EUR 400,000 for the owners. The largest deductions are investments and taxes, followed by the increase in working capital. An acquirer who negotiates the price through a multiple of EBITDA uses exactly this reconciliation to check whether the price is covered by cash flows.

Distinction: free cash flow, operating cash flow and EBITDA

• Operating cash flow: the cash balance from ongoing business before investments. Free cash flow additionally deducts the investments.
• EBITDA: a profit measure before interest, taxes, depreciation and amortisation. It leaves out tax payments, investments and the change in working capital.
• Cash flow positive: describes the state in which the cash flows at a particular level are positive. Positive free cash flow is the stricter form of it.
• Cash flow projection: the multi-year forecast of cash flows in the financial model. It is a planning instrument, while free cash flow is a key figure that can be read from it for each plan year. For short-term solvency, by contrast, liquidity planning is what counts.

Common mistakes

• Forgetting working capital. With strong growth, the increase in receivables and inventories is often as large as the investments.
• Mixing cash flow and interest rate. An unlevered free cash flow belongs with the weighted average cost of capital, a levered free cash flow with the cost of equity. Any other combination distorts the value.
• Terminal value with investments that are too low. If investments in the terminal value stay well below depreciation and amortisation permanently, the valuation assumes shrinking fixed assets alongside growth.
• Overlooking capitalised development. Anyone who looks only at EBITDA does not see that capitalised development costs reduce the available cash surplus.
• Comparing HGB and IFRS financial statements unchecked. The different treatment of leasing leads to differing free cash flows in the same economic situation.

Frequently asked questions

How is free cash flow calculated?

Most simply as operating cash flow minus payments for investments. For valuation, it is derived from EBIT: EBIT after tax, plus depreciation and amortisation, minus investments and the increase in working capital. In the worked example, EUR 620,000 remains from EUR 2.0 million of EBITDA.

Can a company with negative free cash flow be healthy?

Yes. Growth companies deliberately invest more than they earn. What matters is whether the investments lead to higher future cash flows and whether financing is secured until then.

Which free cash flow is used in DCF valuation?

Usually the unlevered free cash flow. It is discounted at the weighted average cost of capital and gives the company value, from which net financial liabilities are deducted.

What is the free cash flow yield?

The ratio of free cash flow to the value of the company (free cash flow yield). Free cash flow to all capital providers fits the company value, and free cash flow to the owners fits the value of equity. If a company with a value of EUR 6.2 million generates free cash flow of EUR 620,000, the yield is 10%. This is the reciprocal of a free cash flow multiple of 10.

What does free cash flow conversion tell us?

It shows what share of EBITDA remains as freely available cash surplus. A high ratio points to a business model with low investment and working capital needs and is often used as an argument in purchase price negotiations.

The Roemer Capital view

Every financial model we build for a transaction carries the planning through to free cash flow and separates maintenance investments from growth investments. Only this separation shows what the existing business earns and what the capital of a new round is used for.

In a sale process, we prepare the reconciliation from EBITDA to free cash flow for the past years and the plan years. Acquirers often negotiate the price through multiples but check it against cash flows. If the reconciliation is in the data room from the start, this check becomes part of our argument.