Generating profit is great, but in the real world, you have to spend money to make money. This is where many beginners get tripped up. A company might show a profit of $1 million, but if it had to spend $2 million on a new factory to get there, it actually "lost" $1 million in cash that year. To find the true Free Cash Flow, we must account for Capital Expenditures (CapEx) and Changes in Working Capital .

Capital Expenditures (CapEx): Building for the Future

CapEx represents the money a company spends to buy, maintain, or improve its fixed assets, such as buildings, vehicles, equipment, or land .

Maintenance CapEx: Money spent just to keep the current business running (e.g., fixing a leaky roof).
Growth CapEx: Money spent to expand (e.g., building a second factory).

In a DCF model, CapEx is a cash outflow. Even though it doesn't appear as a single giant expense on the income statement (it is spread out over years via depreciation), the cash actually leaves the bank account the moment the equipment is bought .

Depreciation: The Non-Cash Add-Back

Depreciation is an accounting "trick" that spreads the cost of a big purchase over its useful life . For example, if TechCo buys a $1,000 machine that lasts 10 years, they record a $100 "depreciation expense" every year for a decade .
However, that $100 isn't a real cash payment—the cash was already spent in Year 0. Therefore, when calculating cash flow, we add back depreciation to our profit because it’s an expense that didn't actually cost us any cash this year .

Working Capital: The Day-to-Day "Float"

Working capital is the money tied up in the daily operations of the business. It is calculated as Current Assets minus Current Liabilities . In a forecast, we care about the change in working capital.

Accounts Receivable (AR): Money customers owe the company. If AR goes up, it means the company made a sale but hasn't received the cash yet. This is a cash outflow .
Inventory: Products waiting to be sold. If inventory goes up, cash is "trapped" in boxes on a shelf. This is a cash outflow .
Accounts Payable (AP): Money the company owes its suppliers. If AP goes up, the company is keeping its cash longer. This is a cash inflow .

Item	Change	Impact on Cash Flow
Accounts Receivable	Increase	Negative (Customers haven't paid yet)
Inventory	Increase	Negative (Cash is tied up in stock)
Accounts Payable	Increase	Positive (Company is delaying payment)

The "Cash Reinvestment" Formula

To get from NOPAT to Free Cash Flow, we use this logic:
FCF = NOPAT + Depreciation – CapEx – Change in Working Capital .

Case Study: TechCo’s Reinvestment

Let’s look at TechCo’s Year 1:

NOPAT: $18.0M
Plus Depreciation: +$2.0M (Non-cash expense)
Minus CapEx: -$5.0M (Buying new servers)
Minus Change in Working Capital: -$1.0M (More inventory needed for growth)
Unlevered Free Cash Flow: $14.0M

Even though the "accounting profit" (NOPAT) was $18M, the company only has $14M in actual "spending money" because it had to reinvest in itself to grow .

Frequently Asked Questions: Reinvestment

Q: Why is an increase in inventory bad for cash flow?
A: It’s not necessarily "bad" for the business, but it is a "use of cash." You had to pay your suppliers for the materials to make that inventory. Until you sell it and get cash from a customer, that money is unavailable for anything else .

Q: Can CapEx be lower than Depreciation?
A: In the short term, yes. This usually happens in "declining" businesses that are milking their old assets and not buying new ones. However, for a healthy, growing company, CapEx is almost always higher than depreciation because they are investing in new growth .

Q: How do I forecast Working Capital for 10 years?
A: A common "beginner" method is to keep Working Capital as a steady percentage of revenue. If it’s usually 5% of sales, you assume it stays 5% of sales. As revenue grows, the dollar amount of working capital grows, creating a small cash outflow every year .