Keeping an eye on the money coming into and out of a company should be one of the business owner’s top priorities. This cash flow is the lifeblood of any business, as it is the revenue generation that keeps operations running smoothly.
Maximizing cash flow can help businesses stay ahead of their expenses and have enough left over to funnel back into the company. One way to optimize a company’s cash flow is through the use of free cash flow. Here’s how you can calculate and use free cash flow to your business’s advantage.
What is Free Cash Flow?
Cash flow refers to the movement of cash, or money, into and out of a company through operating, investing, and financing activities. Free cash flow (FCF) is the total amount of cash on hand that is left over after accounting for these outflows of cash from operations.
In other words, this free cash flow represents the money that exceeds the cost of operating cash outflow and what is leftover from the net cash inflow. Accounts payable and accounts receivable of a business can greatly affect its free cash flow. This unused cash flow is just one aspect that illustrates the overall financial performance of a company.
Business owners use the cash flow statement to help them track cash flow. Tracking can be done manually or automatically with applications and software to generate this statement of cash flows and keep a detailed eye on the inflow and outflow of money.
How to Calculate Free Cash Flow
Calculating cash flow helps business owners understand how much free cash flow their company possesses. The greater the amount, the more money can be reinvested into the business. Such calculations are also made by outside sources, like potential investors and corporate finance analysts, to determine the company’s financial health.
To calculate free cash flow, individuals can use three different formulas to reach the same conclusion. But first, for an FCF formula to work, you will need to gather the business’s financial information below:
Net Income: Refers to the income left over from the total revenue used to cover all of the business’s expenses, including interest payments and taxes. This number is found on the income statement.
Depreciation and Amortization: This covers a business’s assets that lose value over time, as well as the method of breaking down this cost, found on the income statement.
Working Capital: Covers the difference between a business’s current assets and liabilities, or the cash flow used for operating activities and is found on a business’s balance sheet.
Capital Expenditures: The money used to acquire the fixed assets of a business, such as property, plant, and equipment. This number is found on the cash flow statement.
Operating Cash Flow: The cash generated by or used in the daily operations of the business. Cash from operations is calculated on the business’s cash flow statement.
Free Cash Flow Formula
Once you have identified this necessary information from your financial statements, you can determine the business’s free cash flow using one of the following FCF formulas below:
Net Income + Depreciation/ Amortization - Change in Working Capital - Capital Expenditures = Free Cash Flow
Or, more simply put:
Operating Cash Flow - Capital Expenditures = Free Cash Flow
Sometimes businesses do not publish their capital expenditure online, so potential investors and business analysts can calculate FCF using a different formula:
Sales Revenue - (Operating Costs + Taxes) - Required Investments in Operating Capital = Free Cash Flow
Whichever equation you use to assess a business’s free cash flow, you should arrive at the same result.
What Free Cash Flow Tells You About A Business
Cash flow is measured monthly to determine how well the business is doing and whether or not they have the free cash flow to invest back into the company. Positive free cash flow illustrates a healthy financial position, as a business has the means to cover its expenses each month, with money left over.
If the business continues to have positive free cash flows each month, it typically indicates successful growth. On the other hand, if a company has a negative FCF or consistently low free cash flow, adjustments must be made within the business as there is not enough money to cover all operating expenses effectively.
However, a low monthly free cash flow does not necessarily mean the business is in trouble. If large investments are made, or a company is in the middle of expanding, this will affect its bottom line. At the same time, new companies will find it harder to keep consistently high levels of free cash flow as the money is being used to stabilize the budding business. Therefore, it is natural for established enterprises to possess higher levels of free cash flow each month.
Using a Cash Flow Analysis
Businesses use a cash flow analysis to help determine their cash position. This analysis offers a more accurate view of their cash inflow and outflow over other financial documents, such as income statements or balance sheets. Calculating free cash flow is part of this analysis. The analysis of cash flow statements can be used to create a financial projection to help businesses plan for the future and identify where best to place free cash flow for the most optimal results.
Some businesses will use the extra cash on hand to pay off their debt. Entities use the free cash flow to debt ratio to illustrate how much debt can be paid off in one year if all free cash flow was allocated to this debt expense. Companies also use the free cash flow to equity ratio to measure how much money can be used to pay equity to the business’s shareholders and investors.
Routine cash flow analysis also helps to keep an eye on a company’s financial position throughout the year. Overall, companies should use the FCF formulas monthly to ensure there is adequate cash on hand to cover unexpected expenses or future growth opportunities for the greatest benefits to the company.
This article is intended for general informational purposes only and does not constitute legal advice or an opinion on any issue. It should not be regarded as comprehensive or a substitute for professional advice.