A company reports ₹615 crore of net profit and ₹325 crore of free cash flow. Another reports ₹615 crore of net profit and ₹640 crore of free cash flow.
The second one is worth more, and no line in the income statement says so.
Free cash flow is the money left after the business has paid every operating cost, paid its tax, and spent what it needs on assets to keep running and to grow. It's what can actually be handed to lenders and owners, and it's the quantity a discounted cash flow discounts. Everything else is an accounting measure of a period.
The two versions, and why mixing them is expensive
Free cash flow to the firm is measured before any payment to lenders. It belongs to lenders and owners together and is discounted at the weighted average cost of capital, giving an enterprise value.
Free cash flow to equity is measured after interest and after movements in borrowings. It belongs to shareholders alone and is discounted at the cost of equity, giving an equity value directly.
Discounting a pre-interest cash flow at the cost of equity produces an answer that's wrong by roughly the size of the debt, and it's the commonest error in an amateur valuation because both numbers look reasonable in isolation.
Say which one you built. Then use the matching rate.
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Building the firm version from an Indian income statement
Take a manufacturer with ₹4,800 crore of revenue, ₹960 crore of operating profit, ₹380 crore of depreciation, ₹460 crore of capital expenditure and a ₹210 crore increase in working capital, at a 25% marginal tax rate.
Four moves.
First, tax the operating profit at the marginal rate: ₹960 crore times 0.75 gives ₹720 crore of net operating profit after tax.
Then add back depreciation, because it reduced profit without moving money: ₹1,100 crore.
Now subtract capital expenditure, because that did move money: ₹640 crore.
Finally, subtract the increase in working capital, because growth locks cash in inventory and receivables before it comes back: ₹430 crore.
The tax step is the one that trips people up, so slow down here. Taxing operating profit produces a higher charge than the company actually paid, because the real charge is computed after deducting interest. That's deliberate: the tax saving from debt belongs in the discount rate, and counting it in the cash flow as well values the same benefit twice.
Building the equity version from the cash flow statement
Start from operating cash flow. The published statement has already done the working capital and non-cash adjustments and has already deducted tax paid.
Interest is the line to watch. Ind AS 7 puts interest paid in financing for a company outside financial services, so an Indian operating cash flow hasn't paid it yet, and you subtract it here. Take off the whole amount. The tax paid inside operating cash flow is already lower by the deduction the company took for interest, so subtracting only the after-tax cost would count that saving twice.
₹785 crore of operating cash flow, less ₹460 crore of capital expenditure and ₹140 crore of interest paid, plus ₹150 crore of new debt drawn and less ₹90 crore repaid, leaves ₹245 crore for equity.
This version shows something the enterprise route hides. A company funding its growth with new debt is showing shareholders more cash today and more risk tomorrow, and both moves appear on this line.
It's also volatile, because debt is drawn in lumps. Average it across a cycle before you value anything.
The shortcut, and when it is safe
Operating cash flow minus capital expenditure. ₹785 crore less ₹460 crore is ₹325 crore.
It's the version most commonly quoted and it's adequate for screening. Two cautions attach to it.
Whether it's levered depends on whose rules the filing follows, and the answer flips between markets. Ind AS 7 puts interest paid in financing for a company outside financial services, so an Indian operating cash flow is struck before interest and the shortcut comes out near free cash flow to the firm. American filings keep interest paid inside operating, so the same subtraction there produces a figure after interest, closer to free cash flow to equity. Discounting one at the rate meant for the other is the error, and which trap you're standing in depends on the filing in front of you.
Even on an Indian statement the match isn't exact. The tax inside operating cash flow is the tax the company actually paid, already reduced by the deduction it took for interest, while free cash flow to the firm is defined on tax before any such deduction. So the shortcut runs above a clean firm figure by roughly the value of that deduction, and a weighted average cost of capital, which allows for the same relief in its cost of debt, would count the benefit twice.
The year-one trap
One year of free cash flow is close to useless, and it's the mistake most beginners make.
Capital spending is lumpy. A company that commissioned a plant last year and is building nothing this year shows free cash flow that looks transformational and is nothing of the sort. A company mid-way through a capacity build shows almost none and may be creating a great deal of value.
A firm producing ₹325, ₹180, ₹410, ₹90 and ₹500 crore over five years has an average of ₹301 crore, and that average describes the business far better than any of the individual years.
Average across a full investment cycle, or normalise capital expenditure to the level the business needs to hold its position.
Maintenance against growth capital spending
Not all capital spending is compulsory.
Maintenance capital expenditure is what keeps the existing business running at its current size. Everything above it supports growth, and growth spending is discretionary.
No company discloses the split, so you'll have to estimate it. Depreciation is the crude proxy. A better version scales the historical relationship between fixed assets and revenue: if a company has historically needed ₹1 of net fixed assets for every ₹1.65 of sales, then holding sales flat needs enough spending to replace what was consumed, and the rest supports the increase.
A firm spending ₹460 crore of which ₹300 crore is maintenance is committing ₹160 crore to growth. That ₹160 crore is money the owner could have had, and the question is whether the return it earns justifies keeping it.
Owner earnings, which is the same idea stated differently
Warren Buffett's formulation is reported earnings plus non-cash charges, less the capital spending and working capital needed to maintain competitive position.
A company earning ₹615 crore with ₹380 crore of depreciation, ₹300 crore of maintenance capital spending and ₹60 crore of working capital growth produces ₹635 crore of owner earnings.
The measure is a middle ground between accounting profit, which charges an arbitrary depreciation figure, and free cash flow, which subtracts growth spending the owner could choose not to make.
Its weakness is that maintenance capital expenditure is an estimate. Its strength is that making the estimate forces the right question, which is how much of this company's spending is optional.
The working capital release, which flatters a bad year
Cash generated by shrinking the operating cycle is real, but it doesn't repeat.
A firm reporting ₹785 crore of operating cash flow of which ₹300 crore came from a one-off inventory reduction has an underlying run rate closer to ₹485 crore.
Releases cluster in downturns, so free cash flow can look strongest in the year trading was weakest. Sales fall and take receivables and inventory down with them. The balance sheet hands back the cash it absorbed during the growth years.
Strip the working capital line out before you extrapolate. What remains is what the business earns, with the balance sheet's one-off contribution taken out.
Free cash flow yield
Free cash flow divided by market capitalisation. A company generating ₹325 crore against a ₹12,000 crore market value yields 2.71%.
The measure is harder to manipulate than an earnings multiple, because cash after capital spending is difficult to dress up for long. It's also lumpy, so it should be computed on an averaged or normalised figure. A single year will mislead.
Compare it to the ten-year government bond yield. That comparison is the cleanest available statement of what the equity risk is being paid for, and at 2.71% against a 7% bond the answer is that the buyer is paying for growth. Current cash alone wouldn't justify the price.
Three ways the number is made to look better than it is
One is stretching payables. Paying suppliers thirty days later in the last month of the year improves operating cash flow and reverses in April. The disclosure of amounts payable to micro and small enterprises, with interest accrued on overdue payments, is where late payment becomes visible in Indian accounts.
Another is selling receivables. Factoring or bill discounting converts a working capital outflow into a financing inflow. Operating cash flow improves and no customer has paid anything. The arrangement is disclosed in the notes.
The third is capitalising costs. Record a cost as an asset and it leaves the income statement slowly. Its cash leaves through the investing section of the cash flow statement, where the operating line never sees it. Operating cash flow rises, free cash flow doesn't, and anyone quoting operating cash flow alone has been shown a better number.
Your defence against all three is to look past operating cash flow to free cash flow, and to read the notes on receivable financing and on capitalisation policy.
What to do with the number
Free cash flow is an input to two questions and a poor answer to either on its own.
The first is valuation. Normalise it and forecast it before you discount it. Then admit that the terminal assumption supplies most of the answer and the forecast years supply less of it.
The second is capital allocation. Over ten years, add up the free cash flow and note where it went. Then compute the return earned on it. A company that generated ₹4,000 crore over a decade and added ₹1,000 crore of market value has destroyed value while reporting profit growth every year.
You can answer the second question from published accounts, and almost nobody asks it.
Where the number sits in an Indian filing
None of the pieces are labelled, so free cash flow has to be computed from them.
Operating cash flow is the closing figure of the first section of the cash flow statement. Capital expenditure is in the investing section, usually as "purchase of property, plant and equipment" plus any addition to capital work in progress, and it's the figure to use. Additions shown in the fixed asset note can include assets acquired without cash, through a lease or an acquisition, so the note and the cash flow statement disagree for a legitimate reason.
Two adjustments are worth making before you use the number.
Purchases and sales of investments sit in the investing section too and aren't capital expenditure. A company that moved ₹600 crore into liquid funds hasn't spent it, and including that movement makes free cash flow look far worse than it is.
Acquisitions are also in investing and are a separate decision from maintaining the business. Whether to subtract them depends on whether the company is a serial acquirer, in which case they are a running cost, or has done one deal in a decade.
State which treatment you used, and use it consistently for five years.
Reconciling it back to profit, which is where the questions come from
Set net profit and free cash flow side by side for five years and account for the difference each year.
The bridge has four planks: depreciation added back, working capital consumed or released, capital expenditure subtracted, and non-cash charges such as share-based compensation and provisions.
A company whose gap is explained entirely by capital expenditure exceeding depreciation is investing, and the question is what return the investment earns. A company whose gap is explained by working capital growing every year is funding its customers, and the question is why. A company whose gap has no consistent explanation is the one to spend a day on.
Do this once and you'll learn more about a business than any ratio can teach you.
What free cash flow cannot tell you
It can't distinguish a company that spent nothing because it had nothing worth spending on from one that spent nothing because it postponed maintenance.
It can't tell you whether the growth spending will earn a return, which is the question that actually decides the value of the business.
And it says nothing about durability, because a year of strong cash generation from a business whose competitive position is eroding is a year of harvesting rather than of earning.
So treat the number as an input. The two questions it feeds are what the business is worth and what management did with the money, and the second one is answerable from published accounts and almost never asked.
The ten-year question this number exists to answer
Add up ten years of free cash flow. Add whatever was raised from debt and equity over the same period. That total is the money that passed through management's hands. Now list where it went: capital expenditure, acquisitions, dividends, buybacks, debt repayment. Then set the amount reinvested against the change in operating profit across the decade, and the incremental return falls out of the arithmetic. A company that reinvested ₹4,000 crore and added ₹320 crore of operating profit earned 8% on the money. That's a lot of money for that return, and no narrative about strategic positioning survives that calculation. No exercise available from published accounts tells you more. It takes about two hours, and it's almost never done, because it asks a question that neither management nor the sell side has any incentive to raise.
Cash generated, cash deployed, return earned.
Ten years, three numbers.
Everything else about capital allocation is commentary.