what is causing arithmetic overflow in the query below?
I am struggling to find the reason of the arithmetic overflow. why is it happening?


Most likely the metadata is returning some unexpected values that your code cannot handle. For example:

-- Example values returned from sysfiles and FILEPROPERTY
DECLARE 
    @size integer = 1,
    @spaceused integer = 10000;

-- The essence of the code in the question
SELECT
    CAST
    (
        100 * 
        (
            CAST 
            (
                (
                    (@size/128.0 - @spaceused/128.0)/(@size/128.0)
                )  
                AS decimal(5,2)
            )
        ) 
        AS varchar(8)
    ) + '' AS FreeSpacePct;


...returns the error mentioned in the question, because the computed (negative!) value will not fit in decimal(5,2).

There are reasons why size might be reported as much lower than space used, including tempdb file growths, filestream files, bugs in older versions of SQL Server...too many to list. You could/should code defensively against this possibility (and also for offline/defunct files...and so on).

The question is tagged SQL Server 2014, so there's no need to use the deprecated sys.sysfiles view (for backward compatibility with SQL Server 2000):

I might write this query as:

SELECT
    DatabaseName = DB_NAME(),
    [FileName] = DF.name,
    FileType = DF.type_desc,
    SizeMB = STR(DF.size * Factor.PagesToMB, 10, 2),
    SpaceUsedMB = STR(FP.SpaceUsed * Factor.PagesToMB, 10, 2),
    FreeSpaceMB = STR(FS.FreeSpace * Factor.PagesToMB, 10, 2),
    FreeSpacePct =  STR(Factor.ToPct * FS.FreeSpace / DF.size, 7, 4)
FROM sys.database_files AS DF
CROSS APPLY (SELECT FILEPROPERTY(DF.name, 'SpaceUsed')) AS FP (SpaceUsed)
CROSS APPLY (SELECT DF.size - FP.SpaceUsed) AS FS (FreeSpace)
CROSS JOIN  (SELECT 8e0 / 1024e0, 1e2) AS Factor (PagesToMB, ToPct);


Main advantages:


It separates out the calculation steps
Uses float arithmetic to avoid overflows
STR formats the result and does not raise an error on overflow
It does not cause the error in the question to be thrown


A dynamic SQL version (to collect information for all databases):

DECLARE @SQL nvarchar(2000);

SET @SQL = N'
USE ?;

SELECT
    DatabaseName = DB_NAME(),
    [FileName] = DF.name,
    FileType = DF.type_desc,
    SizeMB = STR(DF.size * Factor.PagesToMB, 10, 2),
    SpaceUsedMB = STR(FP.SpaceUsed * Factor.PagesToMB, 10, 2),
    FreeSpaceMB = STR(FS.FreeSpace * Factor.PagesToMB, 10, 2),
    FreeSpacePct =  STR(Factor.ToPct * FS.FreeSpace / DF.size, 7, 4)
FROM sys.database_files AS DF
CROSS APPLY (SELECT FILEPROPERTY(DF.name, ''SpaceUsed'')) AS FP (SpaceUsed)
CROSS APPLY (SELECT DF.size - FP.SpaceUsed) AS FS (FreeSpace)
CROSS JOIN  (SELECT 8e0 / 1024e0, 1e2) AS Factor (PagesToMB, ToPct);
';

DECLARE @Results AS table
(
    DatabaseName sysname NOT NULL,
    [FileName] sysname NOT NULL,
    FileType nvarchar(60) NOT NULL,
    SizeMB char(10) NULL,
    SpaceUsedMB char(10) NULL,
    FreeSpaceMB char(10) NULL,
    FreeSpacePct char(7) NULL
);

INSERT @Results
EXECUTE sys.sp_MSforeachdb
    @command1 = @SQL;

SELECT R.*
FROM @Results AS R
ORDER BY R.DatabaseName; -- Or whatever


Usual caveats about using sp_MSforeachdb.