Free cash flow

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Free cash flow measures a firm's net increase in

Operating cash flow (this includes the reduction for interest),
less the dividends paid to preferred shareholders, and
less expenditures necessary to maintain assets (often referred to as "capital expenditures" or "Capex").

Increases in non-cash current assets may, or may not be deducted, depending on whether they are considered to be maintaining the status quo, or to be investments for growth.

[edit] Uses of the metric

Free cash flow measures the ease with which businesses can grow and pay dividends to shareholders. Even profitable businesses may have negative cash flows. Their requirement for increased financing will result in increased financing costs reducing future income.
According to the discounted cash flow valuation model, the intrinsic value of a company is the present value of all future free cash flows, plus the cash proceeds from its eventual sale. The presumption is that the cash flows are used to pay dividends to the shareholders. Bear in mind the lumpiness discussed below.
Some investors prefer using free cash flow instead of net income to measure a company's financial performance, because free cash flow is more difficult to manipulate than net income. The problems with this presumption are itemized at cash flow and return of capital.
The payout ratio is a metric used to evaluate the sustainability of distributions from REITs, Oil & Gas Royalty Trusts, and Income Trust. The distributions are divided by the free cash flow. Distributions may include any of income, flowed-through capital gains or return of capital.

This metric is used only by shareholders. Debt holders are not concerned with maintaining the operating capital assets, or with growing the business. Nor are they concerned with taxes paid since their payments come first. The appropriate metric for debt holders is EBITDA.^{[citation needed]}

[edit] Problems with CapEx

The expenditures for maintenance of assets is only part of the capex reported on the Statement of Cash Flows. It must be separated from the expenditures for growth purposes. This split is not a requirement under GAAP, and is not audited. Management is free to disclose maintenance capex or not. Therefore this input to the calculation of free cash flow may be subject to manipulation, or require estimation. Since it may be a large number, maintenance capex's uncertainty is the basis for some people's dismissal of 'free cash flow'.
A second problem with the maintenance capex measurement is its intrinsic 'lumpiness'. By their nature, expenditures for capital assets that will last decades may be infrequent, but costly when they occur. 'Free cash flow', in turn, will be very different from year to year. No particular year will be a 'norm' that can be expected to be repeated. For companies that have stable capital expenditures, free cash flow will (over the long term) be roughly equal to earnings.