You might be familiar with the term “cash flow,” but what exactly is “free cash flow”? While you may think the two terms are interchangeable, the striking difference between these two accounting terms is actually pretty simple.
Cash flow is a statement of your business’s operating cash less all expenses — a measurement of how much comes in and how much goes out. Free cash flow (FCF) on the other hand, is method for determining your business’ value. It’s actually one of the most telling aspects of your company’s financial health, and one that investors are keenly interested in.
What is Free Cash Flow?
Free cash flow measures your company’s financial performance. This metric represents the amount of cash your business generates after you pay all its bills and reinvest the cash back into the company. You can use this cash as profits, to hire more employees, to invest in equipment, or as a way to give more money back to investors.
How to Calculate Free Cash Flow
What does free cash flow measure? Not to be confused with cash flow from operations, free cash flow includes elements of your business’s cash flow from operations, investing, and financing. It is not found on any of the financial statements, and there are no regulatory standards that dictate its calculation. Often referred to as a non-GAAP measure, free cash flow has many variations, but the basic calculation is generally the same.
Free cash flow is a measure of a company’s financial performance. It represents the cash that a company is able to spend on paying dividends or accumulate on its balance sheet after spending the necessary funds to maintain or grow its asset base. Free cash flow is an important measure because it gives the company choices: stash the cash in a reserve fund, buy back shares of outstanding stock, or pay dividends.
To learn how to calculate free cash flow, start with net income and add back any asset depreciation and amortization. Next, subtract changes in working capital and capital expenditures. For example, you have $200,000 in net income and $10,000 in depreciation. You also have a $50,000 increase in working capital and a $40,000 investment in capital expenditures. The calculation looks like this:
- Net income = $200,000
- Add depreciation or amortization +$50,000
- Subtract changes in working capital accounts -$50,000
- Subtract capital expenditures -$40,000
- Free cash flow = $160,000
Depreciation and amortization are considered non-cash transactions, which is why they are added back to net income, and capital expenditures are considered outflows of cash. All together, these three line items provide you with a way to reconcile net income to free cash flow.
Mistakes to Avoid
Due to the lack of regulatory oversight, mistakes can occur in calculating free cash flow, particularly when it comes to the working capital element of the formula. Practitioners disagree on what should be included or excluded given the debated definition of capital expenditure.
At the same time, they might also mean that your company is under-reporting its capital expenditures, depleting inventory, or stretching payables. These activities give a boost to short-term cash flow, but at the expense of long-term business performance.
What Does Free Cash Flow Mean for Your Business?
Armed with the ability to calculate your company’s free cash flow, you may be wondering what it means for your business specifically. As you can imagine, a growing free cash flow is generally a sign of growth, whereas a shrinking free cash flow can be a sign of trouble. Net income can be manipulated for a few quarters with creative accounting methods like those mentioned above (stretching payables, for example), but not free cash flow.
High levels of free cash flow are a positive sign of a business’s financial health. Free cash flow is called ‘free’ because this amount is available for discretionary spending. Businesses with a healthy free cash flow, year after year, are ones that attract investors.
Growth in free cash flow is often a precursor to growth in earnings and vice versa. Your company can have 100% growth in earnings while experiencing a decline in free cash flow due to relaxed credit policies or a temporary buildup of inventory. This is why, as a precautionary measure, business owners like to focus on the drivers of free cash flow over net income.
Because free cash flow is considered a reliable indicator of business performance, financial analysts often use it to calculate the intrinsic value of a company through the discounted cash flow method. Ultimately, free cash flow refers to money that you can take out of your business and spend as you please or invest back into your company.
If the calculations for free cash flow are used correctly in conjunction with other financial statements, you can better gauge the financial health of your company down the line. Improve your cash flow with invoices, payments and expense tracking. See how much cash you have on hand with QuickBooks.