Free cash flow is the cash a business generates from its operations after paying tax and funding the capital expenditure it needs to keep running. No accounting standard defines it, so always check which version is in use: free cash flow to the firm, measured before interest and debt repayments, or free cash flow to equity, measured after them. Lenders use it to judge how much debt a business can service and repay, and buyers use it because it is the cash they can actually take out.
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Is there an official definition of free cash flow?
No. Free cash flow is an analytical measure, not a line in the accounts. FRS 102 Section 7 requires a statement of cash flows split into operating, investing and financing activities (paragraph 7.3), and those headings supply the building blocks, but the standard never adds them up into a free cash flow figure. Small entities do not have to prepare a cash flow statement at all (paragraph 7.1B), so for many owner managed companies the figure has to be built from the profit and loss account and two balance sheets.
ACCA’s technical guidance accepts that different definitions of free cash flow exist, but notes that they all measure cash flow after replacement capital expenditure. That is the common thread: free cash flow is what is left once the business has paid to stand still. See the cash flow statement explained for how the underlying statement is put together.
How is free cash flow calculated?
There are two common routes, and they should reconcile.
Starting from operating profit or EBITDA
- Start with operating profit (or EBITDA).
- Deduct tax on that operating profit.
- Add back non cash charges such as depreciation and amortisation, if you started from operating profit.
- Deduct any increase in working capital (stock, debtors less creditors), or add a decrease.
- Deduct capital expenditure needed to maintain the asset base.
The result is free cash flow to the firm. ACCA’s Advanced Financial Management guidance stresses that this version must exclude interest, because it is discounted at the weighted average cost of capital, which already reflects interest and its tax relief.
Starting from the cash flow statement
Take net cash from operating activities and deduct purchases of property, plant and equipment and intangible assets. Then deduct interest paid and debt repayments (including lease principal) to reach free cash flow to equity. ACCA explains that cash flow measured after debt servicing is a return to shareholders, so it is discounted at the cost of equity, while cash flow before debt servicing is a return to lenders and shareholders together and is discounted at the weighted average cost of capital.
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What does a worked example look like?
Illustration only. A trading company reports the following for the year.
| Item | £000 |
|---|---|
| EBITDA | 1,000 |
| Tax paid | (180) |
| Increase in working capital | (120) |
| Maintenance capital expenditure | (250) |
| Free cash flow to the firm | 450 |
| Interest paid | (90) |
| Scheduled loan and lease repayments | (200) |
| Free cash flow to equity | 160 |
EBITDA of £1m turns into only £160,000 that the shareholders could take out without borrowing more. That gap is exactly why lenders and buyers look past EBITDA.
Why do lenders focus on free cash flow?
A lender is repaid in cash, not profit. HMRC’s International Manual, which describes how third party lenders assess borrowers, puts it plainly at INTM516070: a business may be profitable yet still fail because of a shortage of cash. The same page lists the flaws of EBITDA as a cash measure: it relies on profit and loss figures that include non cash items, it ignores debt repayments, it makes no provision for capital expenditure and it ignores swings in working capital.
INTM516080 describes how a cash flow test is built: deduct capital expenditure, debt repayments, working capital increases, tax and dividends from EBITDA, and check that the surplus covers interest and scheduled repayments, with a ratio above 1:1 because there are other calls on cash. That is free cash flow in all but name, and it is the basis of the debt service cover ratio. ICAEW’s best practice guideline on financial due diligence notes that the due diligence report gives finance providers a view of the target’s “leverageable free cash flow”, which helps them decide the appropriate level of financing.
Why do buyers focus on it?
A buyer pays for future cash. ACCA’s guidance on business valuations notes that the free cash flow model has been tested more than any other equity valuation method in its Advanced Financial Management exam, and the method values a business as the present value of its forecast free cash flows. Its guidance on dividend capacity explains that free cash flow to equity, after the reinvestment needed to maintain operating capacity, is a proxy for what could be distributed to shareholders without impairing the business.
In practice ICAEW’s due diligence guideline lists cash generation, capital expenditure and net working capital trends, and “normalised” requirements, among the areas a financial due diligence report covers. A business that reports rising EBITDA while working capital and capital expenditure absorb the cash will be priced on the cash. For the valuation methods themselves see business valuation methods.
Which accounting choices change the figure?
Free cash flow taken from a cash flow statement depends on classification choices that FRS 102 allows:
- Interest paid may be shown as operating or financing (paragraph 7.15). If it sits in operating cash flow, free cash flow to the firm needs it added back.
- Dividends paid may be financing or operating (paragraph 7.16). Dividends are a use of free cash flow, not a deduction in arriving at it.
- Tax is classified as operating unless it can be specifically identified with financing or investing activities (paragraph 7.17).
- Lease payments: the principal portion of a lease liability is a financing cash flow (paragraph 7.6(e)) and the interest portion is interest paid (paragraph 7.15).
The lease point needs care. The FRC’s Periodic Review 2024 amendments bring most leases onto lessees’ balance sheets for accounting periods beginning on or after 1 January 2026. The IASB’s effects analysis of the equivalent change under IFRS 16 expected it to reduce operating cash outflows because lease principal moves to financing. If free cash flow is simply operating cash flow less capital expenditure, rent effectively disappears from the calculation and free cash flow looks higher with no change in the business. Deduct lease payments as well to keep years comparable.
Should capital expenditure be maintenance or total?
Strictly, free cash flow deducts the capital expenditure needed to maintain operating capacity; spending on expansion is a choice made with free cash flow. In practice the split is judgemental. HMRC’s guidance at INTM515040 warns that depreciation is a poor proxy for replacement spending: new assets usually cost more than the ones they replace, businesses move into new activities, and capital spending tends to be lumpy while depreciation is spread evenly. Its worked example at INTM516070 adds back depreciation of £11.4m and deducts actual capital expenditure of £8.4m. Expect a lender or buyer to ask for several years of capital spending and to challenge any claim that most of it was growth.
What mistakes come up most often?
- Mixing the two definitions, for example deducting interest and then discounting at the weighted average cost of capital.
- Using one year’s figure when working capital or capital spending was unusually low that year.
- Ignoring lease payments after the 2026 lease accounting changes.
- Treating all capital expenditure as growth spending to inflate the figure.
- Forgetting tax, or using the tax charge rather than tax actually paid in the period.
- Comparing free cash flow with net debt calculated on a different basis, for example including leases in one and not the other.
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Related Accountapedia entries
- Cash conversion: operating cash flow to EBITDA
- Normalised EBITDA and add backs
- Interest cover
- Financial covenants in bank loans
- The gearing ratio
Sources
- Financial Reporting Council: FRS 102 September 2024 tmKYWO6
- ACCA: Question values
- ACCA: Business valuations
- ACCA: Faqs
- GOV.UK: Manual page INTM516070
- GOV.UK: Manual page INTM516080
- GOV.UK: Manual page INTM515040
- ICAEW: Financial due diligence guideline 71
- IFRS Foundation: Ifrs16 effects analysis
Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 19 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.