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Cash flow

What is free cash flow and why is it important? Example and formula

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?

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. Dividend 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

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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 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 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

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.

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.

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