It's important to be aware that there is an explicit link between the amount of free cash flow that a firm generates and their return on invested capital. Let's explore that link here. Let's take the example of a company which has $1,000 of invested capital at the start of 20X1 during the year, the company generates 200 of NOPAT. Remember that return on invested capital is NOPAT divided by invested capital, so this company is generating a return on invested capital of 20% during the year. In order to calculate the free cash flow that the company is generating from that NOPAT, we need to add back non-cash expenses, which is depreciation of 100, and then we deduct CapEx of 110. We also deduct the change in working capital of 50. This is just our standard free cash flow calculation, and it gives free cash flow of 140. However, if we dissect this more carefully, we can see that CapEx net of depreciation is 10. But we know from our base analysis of property, plant, and equipment that CapEx net of depreciation is the increase in property, plant and equipment in our balance sheet each year. So the company has effectively made a net investment of 10 in its property, plant, and equipment. Equally, the change in working capital is 50, but we know that this must mean that working capital in the balance sheet has increased by 50. So the company has effectively made net investment of 50 in its operating working capital.

So altogether, the company has made net investment of 60 in its operating assets. Remember that operating assets are its capital employed, and capital employed is the same as invested capital. So invested capital has also increased by 60.

If invested, capital has increased by 60 compared with the opening invested capital of 1,000, this is a 6% increase in the company's invested capital and therefore the company has grown by 6%. Alternatively, we can go the other way and say that if the company needs to grow by 6% and starts the year with 1,000 of invested capital, it needs to reinvest 60 in the business. The free cash flow of 140 is therefore left over after reinvesting 60 of NOPAT. This relationship between return on capital, free cash flow and growth is really important. It can be helpful to think of free cash flow simply as a residual figure. It's what's left over from NOPAT after the company has reinvested what it needs to support business growth. The more we can think of free cash flow as simply NOPAT, less net reinvestment needed to support growth, the more robust our free cash flow forecasts will be.