Updated for the 2026-2027 CFA® Level I curriculum.
Free cash flow connects cash generation with the reinvestment and financing needs of a business. It helps analysts assess amounts available to capital providers, while still requiring scrutiny of working-capital timing and cash-flow classification. This note covers the free cash flow formula for both the firm and equity holders, plus the cash flow ratios that measure performance and debt coverage. Level I tests your ability to calculate these figures from different starting points and interpret what the results mean.
Quick Answer
Free cash flow to the firm (FCFF) is cash available to all capital providers after operating expenses and investments in fixed and working capital. Free cash flow to equity (FCFE) is what remains for common shareholders after debt holders are paid. You calculate FCFF from net income, CFO, EBIT, or EBITDA, then derive FCFE by removing after-tax interest and adding net borrowing. Cash flow ratios measure how well operating cash flow supports revenue, debt, and obligations.
Key Takeaways
FCFF represents cash flow available to both debt and equity holders before any financing payments.
FCFE represents cash flow available only to common shareholders, after debt payments and net borrowing.
You can start the FCFF calculation from net income, CFO, EBIT, or EBITDA. Each starting point requires different adjustments.
FCFE can be derived from FCFF or calculated directly from CFO.
Performance ratios compare CFO to revenue, assets, or equity. Coverage ratios compare CFO to debt and fixed obligations.
Net borrowing (debt issued minus debt repaid) increases FCFE. Net debt repayment decreases it.
What You Need to Know for CFA Level I
The LOS uses the verb "calculate and interpret." Expect both arithmetic and a question about what the number means for the firm's financial position.
This note owns FCFF, FCFE, and cash flow ratio calculations. It does not cover common-size cash flow statement formatting, which belongs to the prior study note.
You must be able to move between net income, CFO, EBIT, and EBITDA as starting points for FCFF.
Interest must always be tax-affected using Int(1 - t) when moving between FCFF and FCFE, regardless of the starting formula.
For the formulas on this page, CFO is on an interest-inclusive basis. Do not subtract interest or working-capital investment again when those effects are already included in the starting subtotal.
Know the difference between a performance ratio (cash generation relative to sales or assets) and a coverage ratio (ability to meet debt and fixed obligations).
How to Calculate Free Cash Flow to the Firm (FCFF)
FCFF measures cash flow available to all suppliers of capital, debt and equity, before any financing distributions. Because it is calculated before interest payments, it is independent of a firm's capital structure. This makes FCFF useful for comparing firms with different debt levels.
FCFF from Net Income
where:
NI: net income,
NCC: net noncash charges (depreciation, amortization, deferred taxes),
Int: interest expense,
t: tax rate,
FCInv: fixed capital investment (net capital expenditures), and
WCInv: working capital investment (increase in net working capital).
Net income already reflects after-tax interest expense as a deduction. Adding back Int(1 - t) removes that financing effect, leaving a measure available to both debt and equity holders.
FCFF from Cash Flow from Operations
CFO already includes the add-back of noncash charges and the change in working capital. This formula is faster when CFO is given directly on the cash flow statement.
FCFF from EBIT or EBITDA
where:
EBIT: earnings before interest and taxes,
EBITDA: earnings before interest, taxes, depreciation, and amortization, and
Dep: depreciation expense.
These versions are useful when the income statement is given but net income and CFO are not directly available.
How to Calculate Free Cash Flow to Equity (FCFE)
FCFE measures cash flow available only to common shareholders after all debt obligations, including net borrowing activity, are accounted for. It is the cash flow basis analysts use for equity valuation models that discount cash flow to equity holders directly.
FCFE from FCFF
where:
Net borrowing: new debt issued minus debt repaid during the period.
Since FCFF already reflects a figure before financing effects, you subtract after-tax interest and add net borrowing to isolate what belongs to equity holders.
FCFE from Cash Flow from Operations
On the stated interest-inclusive basis, CFO already reflects the operating interest payment and tax cash flows. No additional interest subtraction is needed in this FCFE formula. Keep the tax and cash-payment assumptions consistent with the model.
Cash Flow Performance and Coverage Ratios
Cash flow ratios fall into two groups. Performance ratios measure how much operating cash flow a firm generates relative to sales, assets, or equity. Coverage ratios measure a firm's ability to meet debt and other fixed obligations using operating cash flow.
Ratio Type | Ratio | Formula | What It Shows |
|---|---|---|---|
Performance | Cash flow to revenue | Cash generated per dollar of sales | |
Performance | Cash return on assets | Cash efficiency of asset base | |
Performance | Cash return on equity | Cash return earned for equity holders | |
Coverage | Debt coverage | Ability to pay off debt using operating cash flow | |
Coverage | Interest coverage | Cushion available to cover interest payments | |
Coverage | Reinvestment ratio | Ability to fund asset replacement internally |
A higher performance ratio generally signals stronger cash-generating efficiency. A higher coverage ratio signals lower financial risk, since the firm has more cash cushion relative to its obligations.
Working Example
Marlin Corp reports under US GAAP and classifies interest paid as operating. Assume interest paid equals the $40 million interest expense, and the non-cash and working-capital adjustments shown fully reconcile net income to CFO. Amounts are in millions.
Net income: $420 million
Net noncash charges: $95 million
Interest expense: $40 million
Tax rate: 25%
Fixed capital investment: $110 million
Working capital investment: $25 million
Net borrowing: $15 million
Cash flow from operations: $490 million
Total debt: $800 million
Taxes paid: $150 million
Net revenue: $2,500 million
Step 1: Calculate FCFF from net income
Step 2: Calculate FCFE from FCFF
Step 3: Calculate cash flow to revenue
Step 4: Calculate debt coverage
Step 5: Calculate interest coverage
Marlin generates $395 million in free cash flow available to common shareholders after funding reinvestment and servicing debt. A debt coverage ratio of 61.25% means operating cash flow could retire almost two-thirds of total debt in one year if fully applied. Interest coverage of 17x shows ample cushion to meet interest payments, signaling low near-term default risk.
Check the Answer Using the CFO Route
Marlin's CFO already includes the $95 million non-cash adjustment and the $25 million working-capital investment:
The alternative calculations must therefore agree with the net-income route:
Subtracting the $25 million working-capital investment again would double-count it. Likewise, subtracting interest again from the CFO-based FCFE formula would remove a financing cost already reflected in the stated CFO.
Check What the Reported CFO Includes
The CFO formulas above assume operating cash flow includes interest paid, as in Marlin's US GAAP example. If a source statement classifies interest paid as financing, first place CFO on a consistent interest-inclusive basis before applying these formulas. Do not add after-tax interest mechanically to a subtotal that already excludes the cash payment.
Keep cash interest, tax effects, and the interest expense used by the model consistent. Actual taxes paid can differ from the assumed tax shield because of payment timing or deferred tax. State simplifying assumptions when using expense as a proxy for payment.
Common Exam Traps
Double-counting the interest tax shield
With interest paid classified as operating, add after-tax interest once to CFO when calculating FCFF. For FCFE from CFO, make no additional interest adjustment. If interest is classified elsewhere, align the starting cash flow with the formula before applying it. Mixing formulas from different starting points causes this error.
Ignoring the sign of net borrowing
Net borrowing can be negative when debt repayments exceed new issuance. A negative net borrowing figure reduces FCFE. Candidates sometimes treat it as always positive.
Confusing performance ratios with coverage ratios
A question describing debt obligations calls for a coverage ratio like debt coverage or interest coverage, not a performance ratio like cash return on assets. Misreading the scenario leads to the wrong ratio category.
Using the net income formula when CFO is already given
Reconstructing net income into CFO wastes time and introduces arithmetic risk. If CFO is provided, use the CFO-based FCFF or FCFE formula directly.
Practice Question
Orion Industries reports cash flow from operations of $300 million. The company spent $80 million on fixed capital investments during the year and had net borrowing of -$20 million, meaning debt repayments exceeded new debt issued. Calculate Orion's free cash flow to equity (FCFE).
$220 million
$200 million
$240 million
Correct Answer: B
Orion's FCFE is $200 million. The negative net borrowing figure reduces FCFE because the firm used cash to pay down more debt than it raised.
Option A: $220 million results from ignoring net borrowing entirely (300 - 80), leaving out the debt repayment effect.
Option C: $240 million results from treating the net repayment as a positive borrowing inflow (300 - 80 + 20), reversing the sign of net borrowing.
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FAQs About Free Cash Flow to the Firm, Free Cash Flow to Equity, and Cash Flow Ratios
What is the main difference between FCFF and FCFE?
FCFF is cash flow available to all capital providers, debt and equity, before any financing payments. FCFE is cash flow available only to common shareholders after debt obligations and net borrowing are accounted for.
How do you calculate free cash flow to the firm from net income?
Use the free cash flow formula FCFF = NI + NCC + Int(1 - t) - FCInv - WCInv. Add back noncash charges and after-tax interest, then subtract fixed and working capital investment.
Why do analysts use free cash flow instead of net income for valuation?
Free cash flow reflects actual cash available after necessary reinvestment, which is harder to manipulate through accounting choices than net income. It better represents cash that could be distributed to investors.
Is free cash flow to the firm the same as cash flow from operations?
No. CFO is a reported operating subtotal, while FCFF deducts fixed capital investment and removes the financing effect of interest under the model's assumptions. Check the statement's interest classification before converting the reported CFO figure.
What counts as a strong cash flow coverage ratio?
There is no single universal threshold tested at Level I. The exam focuses on calculating the ratio correctly and interpreting direction: higher coverage ratios indicate more cushion against debt and fixed obligations, which lowers financial risk.