Free cash flow (FCF): Equation and meaning

Free cash flow (FCF) is a metric business owners and investors use to measure a company’s financial health. FCF is the amount of cash a business has after paying for operating expenses and capital expenditures (CAPEX), and FCF reports how much discretionary cash a business has available. For investors, free cash flow is an indicator of a company’s profitability, which influences a company’s valuation.

Below, we’ll explore the importance of free cash flow and what it reveals about a company’s financial performance. Keep reading for a comprehensive explanation of free cash flow or navigate directly to a section you’d like to learn more about.

• What is free cash flow?
• Why is free cash flow important?
• How free cash flow works
• When to use free cash flow analysis
• How to calculate free cash flow
• Free cash flow example
• Getting insights from free cash flow analysis
• Limitations of free cash flow analysis
• Defining good free cash flow
• Improving your free cash flow
• Other types of cash flow

What is free cash flow?

Free cash flow, or FCF, is calculated as operating cash flow less capital expenditures. Non-cash expenses, such as depreciation expenses and amortization expenses, are excluded from the calculation. Using FCF requires an understanding of the statement of cash flows and the balance sheet.

Using the statement of cash flows

This statement separates cash inflows and outflows into three categories:

• Cash flows from operating activities: These are the day-to-day activities of managing a business, including inventory purchases, making payroll, and collecting cash from customers.
• Cash flows from investing activities: Cash activity related to purchasing and selling company assets.
• Cash flows from financing activities: When you raise money to operate your business by issuing stock or debt, the cash inflows are posted here. Dividends payments to stockholders are a cash outflow.

FCF includes operating cash flow, and capital expenditures are an investing activity. Financing cash activity is not included in the formula.

Working with the balance sheet

The balance sheet is a financial statement that records a company’s assets, liabilities, and stockholder equity at a certain point in time. A balance sheet acts as the foundation for understanding what the business owns and what it owes, in addition to how much is invested by its owners.

Finally, capital expenditures refers to money a company spends to acquire or maintain any fixed assets, such as equipment or a building.

Why is free cash flow important to small businesses?

FCF differs from a company’s net income. Net income is calculated as revenue less expenses, and FCF excludes many of the revenue and expense accounts.

In addition, net income is calculated using the accrual method of accounting, which recognizes revenue when earned and expenses when incurred to produce revenue. Accrual accounting ignores the timing of cash flows when calculating net income. FCF, on the other hand, focuses on cash flow, and not profit.

How free cash flow works

A company with a positive free cash flow can meet its bills each month, plus some extra. Businesses with rising or high free cash flow numbers are usually doing well and may want to expand. Investors are attracted to companies with rising free cash flow. These firms have excess cash to invest, which can produce a rate of return.

On the other hand, low free cash flow means there’s not much money left over after paying for business expenses. In turn, this makes the business less attractive to investors, as future earning prospects might not be as strong.

When to use free cash flow analysis

If you manufacture or distribute goods, evaluating your free cash flow can be a useful process. This method can measure your business’s success and whether it’s in a position to expand or restructure, or if it has a high probability of earning profits.

To use free cash flow analysis, you’ll need both accurate accounting and reporting. Accounting software like QuickBooks can be helpful for tracking and managing your company’s financial needs. You’ll be able to obtain deeper insights into financial trends and patterns that can make your business decisions easier.

As explained above, the simplest way to calculate FCF is by using the following formula:

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

But if a company doesn’t list out its operating cash flow or capital expenditures, you can use alternative formulas that give you the same information.

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

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

Free cash flow example

Let’s look at an example of free cash flow using the first formula above. Company A reports operating cash flow of $700,000 on its annual cash flow statement for 2020. Over the year, Company A spent $300,000 on warehouse equipment.

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

$400,000 (free cash flow) = $700,000 (operating cash flow) – $300,000 (capital expenditures)

So, Company A’s free cash flow is $400,000.

Getting insights from free cash flow (FCF) analysis

Free cash flow can give you insight into the health of a business. A large amount of free cash flow can mean that you have enough money to pay your operating expenses with some leftover. That leftover amount can be used for distributions to investors, reinvestment in the business, or stock buybacks.

FCF can also indicate potential business moves:

• Restructuring: Businesses that are growing might see negative free cash flow as more money goes into expansion. But consistently negative or low free cash flow can mean your business might benefit from restructuring. The restructuring would ideally lead to a positive free cash flow.
• Expansion: If your company regularly has high free cash flow numbers, it may indicate that the business is poised for expansion. That might mean investing, acquiring another business, adding on an office, or hiring more employees.
• Earnings surge: Investors often evaluate and look at a company’s free cash flow before deciding to invest. Consistently high free cash flow may indicate good earnings prospects for the future.

Limitations of free cash flow analysis

While FCF can be a useful metric, it’s not perfect. Let’s look at some of its limitations. 

Depreciation

Unlike a metric like net income, FCF doesn’t account for depreciation. Why? It’s a non-cash expense, meaning it’s a business cost that doesn’t involve a cash transaction. FCF focuses on actual cash flows, sometimes making a business’s FCF seem higher than its net income.

For instance, if a company buys a piece of equipment for $100,000, it might depreciate the cost over 10 years — i.e., $10,000 is deducted from the net income each year. However, since they spent the cash upfront, FCF will show the full $100,000 in the year of the purchase but none in the following years. As a result, the FCF might look stronger in the subsequent years because it doesn’t account for the ongoing depreciation expense, while net income still reflects the annual depreciation deduction.

So, relying solely on FCF without factoring in depreciation can skew your understanding of a company’s financial position.

Industry-specific considerations

Different industries have varying levels of capital expenditures. For example, a financially stable construction company may have low FCF, but it’s likely because they have to invest heavily in machinery, equipment, and maintenance. On the other hand, a struggling e-commerce platform may have a high FCF because it operates primarily online and doesn’t require a huge investment in physical assets. 

If you’re looking at FCF without considering the context, you might assume the e-commerce platform is doing better than the construction company, even though the opposite is true. That’s why you must look beyond FCF and consider the industry norms to fully understand a company’s financial health.

One-time events

Sometimes, your company might have to make a one-off, non-recurring payment. Let’s say your business sells a warehouse, which would boost your FCF for that year. While this surge of cash might make your financials look strong, it’s not a true representation of your ongoing cash flow from your core operations. This spike is temporary and likely won’t continue in future years. If these one-time events happen, just be sure to consider them so you don’t draw inaccurate conclusions about your financial performance.

Growth and expansion

It’s important to know that a low free cash flow doesn’t mean a business is failing. Successful companies will see a drop in their free cash flow amounts during periods of growth. Acquisitions and new product launches, for example, will result in a temporary dip in free cash flow.

Take a look at the natural fluctuations of a big, successful company like Apple, for example. As the chart shows, over a five-year period, the company’s free cash flow dips routinely before rising again.

Defining good free cash flow

What’s considered “good” free cash flow can vary depending on your company’s size, industry, growth stage, and other factors. But generally, a good FCF means you have enough money to pay your bills and day-to-day expenses for the month and still have cash on hand to invest in your business. 

Consistency is another sign of healthy FCF. Large fluctuations in FCF can make it difficult to plan for the future, but when your FCF is stable month after month, it makes it easier to budget for things like new projects, equipment grades, and expansion opportunities. You may even attract or give confidence to investors because this consistent FCF shows your business is well-managed and financially reliable. 

If you want to measure your FCF’s health, calculating your FCF margin is one way you can do it. Most companies aim for an FCF margin of 10% to 15% because it shows they’re generating cash flow from their core operations. Here’s the formula:

• FCF Margin = FCF/Revenue

So, if your company has $1 million in revenue and $100,000 in FCF, your FCF margin would be 10%.

Improving your free cash flow

Could your FCF use a bit of improvement? Here are some strategies to help maintain a healthy FCF:

Keep an eye on spending

There will always be necessary expenses you have to make when running your business, but look at some of your spendings that may be nonessential. Are you paying for software or subscriptions you no longer use? Reducing or eliminating these types of expenses can free up cash without affecting your day-to-day operations.

Also, don’t be afraid to negotiate with your suppliers. For example, if you’ve built a good relationship, ask for a 5-10% discount in exchange for paying invoices early or request extended payment terms — like net 60 instead of net 30— so you have more time to manage your cash flow.

Increase sales revenue

You should also focus on ways to help increase the cash coming into your business. One of the best ways to do this is by upselling. For example, if you run an auto shop and a customer only wants an oil change, take the opportunity to inspect their car for other potential issues, like worn tires or brake pads that need replacing. You can boost your sales and possibly gain a loyal customer by showing a commitment to their safety and vehicle health.

Loyal programs are another way to keep customers coming back and spending money. Sticking with the auto shop example, you could offer a punch card and mark each time they get an oil change. When they reach their fifth oil change, they’ll receive a free one.

Optimize inventory management

If your business handles inventory, you may need to reassess your inventory management. Excess inventory means you’ve spent money on products that are just sitting on your shelves instead of generating revenue. On the other hand, understocking can lead to lost sales and frustrated customers.

To help avoid these pitfalls, consider inventory management software that allows you to track your stock levels in real time so you can prevent over-purchasing. If you notice some slow-moving items, think about offering discounts or promotions to clear out this excess inventory and start getting money back into your business.

Manage receivables

Do you have customers who are slow to pay invoices? It can put a strain on your FCF and make it harder to cover your day-to-day expenses. 

First, make sure you clearly state your payment terms on every invoice and be upfront about any late fees or penalties for missed payments. You may also want to offer an early payment incentive. For instance, a 2% discount for paying within 10 days can help speed up your cash flow without cutting too deeply into your profits.

Additionally, don’t hesitate to follow up and send reminders. Using invoice software makes it easy to automate this process, so reminders go out on time, and you can track payments more efficiently.

Other types of cash flow

When corporate finance experts discuss “cash flow,” they may be referring to a few different metrics. Below are some of the common ways financial professionals measure the value and financial health of a particular business.

Earnings before interest, tax, depreciation, and amortization (EBITDA): EBITDA measures a company’s operating performance. To get EBITDA, you’ll need the net income plus tax expense, interest expense, depreciation expense, and amortization expense. This metric focuses on a business’s operational profitability from its main operations before the impact on capital structure.

Cash flow from operations: Otherwise referred to as operating cash flow, this measures the cash generated or used up by a company from its day-to-day operations.

Free cash flow to equity (FCFE): FCFE is measured as (cash from operating activities – capital expenditures + net debt issued). Debt that is repaid is subtracted from the formula.

Free cash flow to the firm (FCFF): This formula is (net operating profit after tax + depreciation and amortization expenses – capital expenditures – net working capital. This formula is also referred to as unlevered free cash flow, and FCFF reports the excess cash available if the business had no debt.

Wrapping up: Free cash flow and metrics of success

A company’s FCF is one of many tools that can be used to measure its financial health. For small business owners, FCF helps you determine if your company is able to expand or restructure, or if it’s likely to see a growth in profits. If you’re struggling to track the metrics of your company’s financial health, QuickBooks can help. Our accounting software is designed to streamline your accounting and reporting tasks so you can focus on the important things, like growing your business.

Disclaimers: Based on U.S. Intuit Assist Beta customers using outstanding invoice notifications and AI-drafted invoice reminder features, compared to customers sending standard invoice reminders to the same customers, from January 2024 to August 2024. Not available in QuickBooks Online Advanced.