Free cash flow measures cash a company actually generated and kept after funding its own operations and investments — a harder number to manipulate than accrual-based net income.
The Formula and Why It Matters
Free cash flow = operating cash flow − capital expenditures. Unlike net income, which includes non-cash accounting items (depreciation, amortization, certain accruals), FCF reflects actual cash moving in and out — the money available for dividends, buybacks, debt paydown, or reinvestment without needing to raise more capital. A company can report positive net income while burning cash if working capital needs or heavy capex are consuming more than the income statement shows.
Practically, this means: A persistent gap where net income is consistently positive but free cash flow is consistently negative or much lower is a genuine red flag worth investigating — it can signal aggressive revenue recognition, rising receivables that aren't being collected, or capital intensity the income statement understates.
Someone Evaluating Dividend Sustainability: Check free cash flow, not just net income — a dividend paid from cash flow that doesn't actually exist is a sustainability risk.
Someone Seeing Net Income and FCF Diverge Sharply: Investigate the cause — rising receivables, heavy capex, or working capital swings are the usual drivers.
Use FCF the Way
- Compare net income to free cash flow over several quarters.
- Check FCF before trusting a dividend's sustainability.
- Investigate any persistent, large gap between the two figures.
See dividend yield explained for how this connects to income investing.
