What is a free cash flow? Since we're trying to calculate the enterprise value of the business, we're going to need a cash flow generated by the business before we worry about having to make any payments based on how much debt or equity we have. Another way to look at this is to say it's the cash. Our business would have generated for our shareholders if we had no debt or the business were unlevered. A free cash flow is generated by the Enterprise Value part of the business meaning it is essentially the cash flow available to pay all providers of finance, date and equity providers after satisfying all other necessary cash flows of the business.

So how do we calculate the free cash flow for a business? Since we're looking at the cash flows that have been generated before any cash flows to do with our financing such as interest payments on debt new debt being issued or dividend payments on equity. We must be looking at the operational cash flows of the business the cash generated from the day-to-day operations of the company. This includes the effect of paying staff salaries investing in new property plant and equipment or capex or investing in inventory, for example the easiest number to start with is one you can get from the income statement operating profit or EBIT if adjusted for non-recurring items. However, operating profit or EBIT in the income statement isn't the same as free cash flow. So we're going to have to make a few changes. Firstly operating profit or EBIT is before tax, and we've got to pay tax to the government before we can start returning capital to our investors. So we're going to have to deduct tax from operating profit. This gives us a metric called net operating profit after tax or NOPAT. This number can also be called EBIAT or earnings before interest after taxes. One thing to be careful with here is that the tax we're deducting is not the same as the tax expense from the income statement that is because the tax expense in the income statement includes the effect of any interest payments and we want a cash flow here that is free from the impact of financing. So we have to calculate tax ourselves by multiplying EBIT by the long run tax rate or the effective tax rate. Once we have NOPAT or EBIAT we then have to ask ourselves. Is this really the cash flow from the business? Well, no, we've included depreciation and amortization in operating profit in the income statement. These are both non-cash expenses. So we need to add them back. We also need to subtract real cash flows that have gone into the operations of the business, but aren't included in operating profit. Capex is a great example of this. Capex is an investment in the operations of the business by buying things like property plant and equipment. But accountants reflect this by adding an asset rather than an expense in the income statement. Both of these last two adjustments impact to the same line of the balance sheet depreciation results in long-term assets going down and capex results in them going up. So a shortcut that can be used in place of these two adjustments is to deduct the change in long-term assets from the balance sheet.

We also need to subtract any increases in operating working capital or add any decreases in operating working capital and also look at any changes in other operating assets or liabilities. This allows us to turn the accrual accounting operating profit from the income statement into a cash flow figure. Once we've made all of these adjustments, we finally gotten through to the free cash flow, cash flow produced by the operations of the business, which could be returned to our financiers.