• What is free cash flow (FCF)?
• How do you calculate free cash flow?
• Free cash flow formulas
• Free cash flow example
• What does free cash flow indicate?
• How to analyze free cash flow
• The benefits of free cash flow
• The pitfalls of free cash flow
• Using free cash flow to make your business grow
• FAQ

As a small business owner, free cash flow is a powerful indicator of your company’s financial health.

In a recent survey by the Canadian Federation of Independent Business (CFIB), 1 in 5 businesses reported that their financial situation was their biggest challenge. Unlike regular cash flow, which simply tracks the money moving in and out of your business, free cash flow provides deeper insight into your business’s true value. Since it can determine how much liquid cash you can invest to grow your business or pay down debt, it’s a key factor for attracting potential investors.

Read on to learn more, including what is free cash flow, how to calculate it, and how it can impact your business. 

What is free cash flow (FCF)?

Free cash flow reflects the amount of cash your business earns after covering all expenses and capital expenditures. It is a key indicator of your company’s financial performance.

This excess cash provides your business with various growth opportunities. Whether you decide to use it as profit, to hire more employees, to invest in new equipment, or to return value to investors through dividends, free cash flow provides you with valuable options. 

You can also choose to accumulate this cash on your balance sheet, create a reserve fund, or buy back shares. These strategies will help ensure that your business is sustainable for the future.

How do you calculate free cash flow? 

Free cash flow includes elements of your business’s cash flow from operations, investing, and financing. However, it doesn’t appear in any of the financial statements. That’s why there’s no regulatory standard on how it should be calculated. 

Often referred to as a non-GAAP (generally accepted accounting principles) measure, free cash flow has different variations, but the core formula is typically the same. 

Free cash flow formulas

There are several ways to calculate free cash flow. The easiest way to calculate FCF is by using the following formula:

Main formula:

Free cash flow (FCF) = operating cash flow – capital expenditures

However, if a company doesn’t itemize its operating cash flow or capital expenditures, there are two alternative formulas that will derive the same answer.

Alternative #1: 

Free cash flow (FCF) = sales revenue – (operating costs + taxes) – required investments in operating capital

Alternative #2: 

Free cash flow (FCF) = net operating profit after taxes – net investment in operating capital

Free cash flow example

Let’s look at an example using the first formula above.

Restaurant ABC reports an operating cash flow of $350,000 on its annual cash flow statement for 2024. Over the year, the business spent $100,000 on kitchen equipment.

To calculate the restaurant’s free cash flow, you can use the following formula:

$250,000 (free cash flow) = $350,000 (operating cash flow) – $100,000 (capital expenditures)

Therefore, Restaurant ABC’s free cash flow is $250,000.

What does free cash flow indicate?

Free cash flow represents the cash produced by your business that is free of obligations.

Generally, growing free cash flow is a sign of business growth, while diminishing free cash flow may mean trouble ahead.

Free cash flow also provides a reliable indicator of your company’s overall financial well-being, which can help you make informed decisions and attract potential investors.

How to analyze free cash flow

To gain a true understanding of free cash flow, you need to understand the underlying trends. For example, a lower number of accounts payable on your ledger may indicate that suppliers are asking for faster payment times, whereas a reduction in accounts receivable could suggest faster collections from your clients. 

By analyzing your free cash flow, you can get an understanding of the working capital that may not be apparent on an income statement. This exercise can help you find possible issues, such as an increase in unsold inventory, delays in customer payments, or suppliers demanding quicker payment times. 

Knowing this information can help you be more proactive in making the right decisions about how to operate your business.  

The benefits of free cash flow 

A healthy amount of free cash flow is a good indication that your business is thriving. When you have free cash flow, it allows you to:

• Use it as profit.
• Hire additional staff.
• Repay lenders.
• Purchase new equipment.
• Expand your business operations.
• Pay dividends to shareholders.

When free cash flow increases over time, it may lead to increased earnings and stock value, which could appeal to investors. Investors value this key metric, as it shows growth potential.

The pitfalls of free cash flow 

Despite its benefits, free cash flow has potential downsides. Here are some common pitfalls:

• Miscalculations can happen. This is especially true when there are disagreements regarding what should be included or excluded from the formula.
• Short-term boost could lead to long-term bust. A high amount of free cash flow may occasionally result from delaying important investments, under-reporting capital expenditures, or extending the payables. All of these variables can boost short-term cash flow but may hinder long-term performance.
• It is sensitive to economic conditions. Free cash flow may be influenced by macroeconomic factors such as interest rates, inflation, and corporate tax rates. 

As a result, while free cash flow is a valuable metric, it’s important to interpret it by considering the big picture of your organization’s financial strategy.

Using free cash flow to make your business grow 

Free cash flow measures the ability of your business to pay off debt and generate dividends and interest to give to investors. It’s also used in combination with financial statements to help you estimate the financial health of your company. 

Using this formula can help reveal underlying problems that can be tackled before they impact your bottom line.

Ultimately, free cash flow gives you the flexibility to take the money and spend it as you please or invest it back into your company. 

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