No business can survive for long without any money coming in. That is why cash flow in general is so important. But this broad concept of cash flowing in and out of the business every month, quarter or year tells you little about the overall performance or health of a business.
To discover how healthy a company's cash position really is, you need to know its free cash flow. Free cash flow calculates the increase or decrease in cash that a company has at its disposal at the end of any given period.
How to calculate free cash flow, with formula
While cash flow is a general measure of a company's incomings and outgoings, free cash flow reveals how much money is left after subtracting all operating costs and investment expenses from revenue. This is measured over a set period, such as month by month. Free cash flow can be easily calculated using the following formula:
Free Cash Flow = Cash From Operations - Capital Expenditure
Cash from operations
Operating cash flow is a measure of the cash generated by a business from core activities. It is calculated by taking the revenue generated from normal commercial activities, such as sales, manufacturing or service provision, and deducting operating expenses.
Capital expenditures
Capital expenditure is the money spent by a business on buying, maintaining, or upgrading fixed assets, such as land, buildings, or equipment.
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Free cash flow uses the cash accounting method, where payments and receipts are logged when the money arrives and leaves, not when the transaction is agreed, known as the accrual method. Depreciation and amortisation are excluded from free cash flow. These are financial projections of the falling value of capital assets; no cash changes hands during the period in question, so they do not appear in the free cash flow calculation.
Free cash flow example
A company sells umbrellas for £10 a unit. In a single year of trading the business sells 11,000 umbrellas, 10,000 of which are cash sales paid immediately, and the remaining 1,000 are under contract for future payment.
For the financial year, the company's cash revenue stands at £100,000 from the 10,000 umbrellas sold instantly for cash. The potential £10,000 revenue from the 1,000 umbrellas under future contracts is excluded. This is because free cash flow focuses solely on cash transactions, excluding future commitments.
To calculate free cash flow, costs must be deducted from this revenue. There are operating costs, such as the materials for the umbrella, like wood, metal spokes and fabric panels. There are also labour costs and factory utility expenses.
Once operating costs have been accumulated, it is time to deduct capital expenditures. These include machines for the factory, new computers for the sales team, and payment for a new piece of land for future development. If taxes are paid, these are included as costs.
Once you have deducted capital expenditures from operating costs, the company is left with its final free cash flow figure. It is a factual measure of the money generated or lost during a specific period, in cash rather than theoretical or contractual terms.
Using free cash flow
Free cash flow shows the actual cash a business generates or loses in a period. Ambitious contracts that may or may not be paid are not considered, as free cash flow uses only numbers based on cash transactions that have been completed.
“The easiest way to think of free cash flow is that it's profit that has landed and is available,” says Stuart Crook, partner at Wellers Small Business Accountants. “Capital expenditure, acquisitions and dividends are included because they are cash transactions. If money goes out the door, it's part of free cash flow.”
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Free cash flow vs EBITDA
Free cash flow is used in conjunction with another valuable accounting measure: earnings before interest, tax, depreciation and amortisation (EBITDA).
Business owners may think of the two metrics as:
- EBITDA: profit before tax, loans and adjustments.
- Free cash flow: profit after tax, loans, and other costs are paid.
Each uses a different timing method:
- EBITDA is accruals-based. Transactions are recorded when an agreement is made.
- Free cash flow is cash-based. Transactions are recorded when payment is made or received.
Both are needed for an accurate picture. Finn Wheatley, a financial expert and risk analyst at The Small Business Blog, says free cash flow helps make up for some of the deficiencies of EBITDA. These include its failure to account for the need for working capital and paying off debt, which are necessary costs that affect how much cash is left over at the end of the day.
"Free cash flow goes one step further than EBITDA because it also takes capital expenditures out of operating cash flow. This shows how much money is left over after buying property, plant, and equipment for the business. So, free cash flow gives a more accurate picture of how much financial freedom a company has.”
Advantages and disadvantages of measuring free cash flow
Advantages
Free cash flow is a powerful measure for identifying how much money a company will have at the end of a financial period. This is because it is based on transactions when they occur, not when they are agreed or scheduled. It is also all-inclusive: if money is entering the business or leaving it, then these transactions are factored into free cash flow.
It is therefore an essential indicator for business owners. The most critical use is to avoid running out of money and being unable to meet obligations when they fall due (known as being insolvent).
Disadvantages
A downside to free cash flow is that it includes anomalies, and therefore may be a poor guide to the core performance of the business. For example, if taxes rise and are paid, this will lower free cash flow despite core business operations being unchanged. This is also true of interest rates: if rates rise the monthly payments on a loan may increase, depressing free cash flow. Both of these are outside the control of the business managers and do not reflect any change in the core activities of the organisation.
EBITDA is preferred by investors for this reason: it states profits before the impact of taxes, interest, and other non-core elements, to offer a snapshot of the performance of the company without external elements obscuring the picture.
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