Free Cash Flow: What it is and how to calculate it

Free cash flow (FCF) is what 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 the free cash flow formula and what it reveals about a company’s financial performance. Keep reading for a comprehensive explanation of the free cash flow formula, 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
• Free cash flow formula example
• Getting insights from free cash flow analysis
• Limitations of free cash flow analysis
• Other types of cash flow

What is free cash flow?

Free cash flow, or FCF, is calculated as operating cash flow minus capital expenditures. Non-cash expenses, such as depreciation expenses and amortisation expenses, are excluded from the calculation. Using FCF requires an understanding of company financial statements like 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 stock 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 and how much is invested by its owners.

Finally, capital expenditures refer to the money a company spends to acquire or maintain 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 minus expenses, and FCF excludes many of the revenue and expense accounts.

In addition, net income is calculated using the accrual method of accounting, which recognises revenue when earned and expenses when incurred to produce revenue. Accrual accounting ignores the timing of cash flows when calculating net income. On the other hand, FCF focuses on cash flow, not profit. In other words, how much cash a company has at a given time. Net income can include accounts payable and accounts receivable.

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 usually do well and may want to expand. Investors are attracted to companies with increasing 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 not much money left over after paying for business expenses. 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 useful.. This method can measure your business’s success and whether it’s in a position to expand or restructure or have a high probability of earning profits.

To use free cash flow analysis, you’ll need accurate accounting and reporting. Accounting software like QuickBooks can help track and manage 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 free cash flow formulas:

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 formula example

Let’s look at an example of free cash flow using the first formula above. Company A reports cash from operations of R700,000 on its annual cash flow statement for 2020. Over the year, Company A spent R300,000 on warehouse equipment.

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

R400,000 (free cash flow) = R700,000 (operating cash flow) – R300,000 (capital expenditures)

So, Company A’s free cash flow is R400,000.

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 you have enough money to pay your operating expenses with some leftover. The free leftover amount can be used for distributions to investors, reinvestment in the business, or Stock buybacks.

FCF can also indicate potential business moves:

• Restructuring: Growing businesses 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 growth. That might mean investing, acquiring another business, adding an office, or hiring more employees.
• Earnings surge: Investors often evaluate and look at a company’s free cash flow before investing. Consistently high free cash flow may indicate good earnings prospects for the future.

Limitations of free cash flow analysis

It’s important to know that a low free cash flow doesn’t mean a business is failing. Also make use of the discounted cash flow method to determine the value of a business or investment. 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. As the chart shows, the company’s free cash flow dips routinely before rising again over a five-year period.

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 a particular business's value and financial health.

Earnings before interest, tax, depreciation, and amortisation (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 amortisation 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 calculated 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 amortisation 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 can expand or restructure or if it’s likely to see a growth in profits. If you’re struggling to track your company’s financial health metrics, 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.