Free cash flow is a useful measure designed to provide owners and investors with the true profitability of a company.
Free cash flow (FCF) can be a tremendously useful measure for understanding the true profitability of a business. It's harder to manipulate and it can tell a much better story of a company than more commonly used metrics like net income.
Overview: What is free cash flow?
Different from operating cash flow, free cash flow measures how much cash is generated by a business after capital expenses such as buildings and equipment have been paid.
Free cash flow can be used in a variety of ways, including business expansion, paying down debt, or paying additional dividends to your investors. If you have a very small business, it’s likely you’re more focused on basic bookkeeping tasks and have no need to calculate free cash flow.
However, if your business is growing, you’re looking to expand your business, or you have a tremendous amount of investments, chances are that calculating your free cash flow can be beneficial.
You can calculate either levered free cash flow or unlevered free cash flow, the difference being that levered free cash flow indicates the amount of cash a business has after paying all business related expenses, while unlevered free cash flow is the amount of cash a business has before it has paid expenses.
Why is free cash flow important for your small business?
You may have heard someone say that "you can't pay your bills with net income." Whether we're talking operating expenses such as salaries, utility bills, construction on a new factory, or dividends, it's all paid in cash, no matter which accounting method you currently use in your business.
Thus, it measures the business's ability to generate cash that really matters. Here are some other reasons why free cash flow is important:
1. It provides your business with growth opportunities
If you’re looking to expand operations or even invest in another business, free cash flow can help your business do that. It can also provide you with the means to add additional locations, expand your current operation, or even bring additional employees on board.
2. It can help attract investors
Consistent free cash flow is particularly important to current and potential investors, as it shows exactly how much cash a company currently has to use, signaling to investors that the company they are interested in has the ability to pay down current debt, buy back stock, or pay dividends.
3. It can provide a measure of financial health
While it’s not the only indicator, consistent free cash flow can be a strong indicator that a business is stable and will likely remain in business.
How to calculate free cash flow
There are several methods for calculating free cash flow, but the most common method is also the easiest calculation. To calculate free cash flow, all you need to do is turn to a company's financial statements such as the statement of cash flows and use the following FCF formula:
Cash flow from operations - capital expenditures = free cash flow.
Typically, because of the volatility in free cash flow, you'll find that it's best to observe free cash flow over a period of a few years rather than a single year or quarter.
Let’s use Joe as an example. Joe owns a small plant that manufactures airplane parts. For fiscal year 2019, Joe reported operating cash flow of $774,000 on his annual cash flow statement. In that same period of time, Joe spent $295,000 on two new machines for the plant. Here’s how Joe would calculate free cash flow:
$774,000 - $295,000 = $479,000
That means that Joe has $479,000 in free cash flow that can be used in his business.
There is another way that you can calculate free cash flow. That formula is:
Net Income + Depreciation/Amortization - Change in Working Capital - Capital Expenditure = Free Cash Flow
In this formula, you need to access both your income statement and your balance sheet in order to obtain net income and depreciation and amortization expenses.
Next, you’ll need to calculate your working capital, which is done by subtracting current liabilities from current assets. Finally, you’ll subtract your capital expenditures in order to arrive at your free cash flow.
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What free cash flow can tell you about your small business
Free cash flow can tell you a lot about the health of your business. Having a substantive amount of free cash flow says that your business has plenty of money to pay your bills, with a healthy amount left over that can be used in a variety of ways, including distribution to investors.
Businesses with free cash flow might also expand or acquire another business to add to their portfolio.
Here are some other things that free cash flow can tell you about your business:
- Whether to expand your business: Having free cash flow indicates that your business is in a good position to expand. This expansion can mean anything from adding an additional office, hiring more employees, or even investing in or acquiring a competing business.
- Whether earnings may increase: Investors frequently look at a company’s free cash flow prior to investing. Why? Because consistent free cash flow can indicate a possible surge in future earnings, making the business a much more attractive investment.
- Whether you need to restructure: Just about every growing business has faced negative free cash flow at one time. Consistent low or negative free cash flow may indicate that your business needs to look at possible restructuring in order to raise free cash flow levels.
Not all companies will use free cash flow as a measure of financial success or stability.
Companies that don’t typically make any long-term investments as part of their business model such as service businesses or financial institutions or banks will be better served using net income as an indicator of financial performance, whereas a manufacturing company that typically invests in factories or heavy equipment will be better served using free cash flow as an indicator of financial performance.
Can calculating free cash flow help your business?
If you manufacture or distribute products, measuring free cash flow can be beneficial. Keep in mind that free cash flow is similar to retained earnings, though retained earnings are calculated on an accrual basis while free cash flow is calculated on a cash basis, making the resulting number more useful to potential investors.
Whichever method you use to measure your company’s success, they both rely on accurate accounting and reporting capability.
If you’re looking for accounting software that can help manage your financial transactions and provide you with accurate financial statements, be sure to check out The Ascent’s accounting software reviews.
