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What is free cash flow?

What Is Free Cash Flow? Find Out If Your Business Is Really Growing

Last updated: January 8, 2020
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Getting the full picture of how your business is doing is impossible if you’re only considering the revenue you earn. While knowing how much cash you’re raking in is important, understanding the impact of your expenses will help you be realistic and make the smartest decisions. That’s where free cash flow comes into play.

Free cash flow is one of many business terms you need to know when creating your own company. Often abbreviated as FCF, this measurement is one of the best ways to find the true value of a company.

Keep reading to learn more about what free cash flow is and how to calculate FCF.

What Is Free Cash Flow?

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Free cash flow is the difference between your operating cash flow and your capital expenditures. Let’s break down these two terms:

  • Operating cash flow, sometimes known as cash flow from operations or CFO, is the net income your business earns from its everyday operations after adjustments for depreciation and taxes. Most business analysts additionally adjust for changes in working capital to provide a more precise calculation. Operating cash flow does not include revenue or expenses from financing or investing activities and is often recorded in a statement of cash flows.
  • Capital expenditures, sometimes known as CapEx, are the funds that your business uses to acquire, repair, or even improve physical assets. These physical assets may include your office building, equipment, and company vehicles.

The purpose of calculating free cash flow is to help you get a clearer picture of your company’s financial health. It’s a great measurement when you want to understand how much cash your company has to invest in expansion, new products, and more. Growing FCF is an indicator of a positive growth rate that can benefit all stakeholders.

Why Do I Need to Calculate Free Cash Flow?

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Calculating free cash flow is necessary for understanding when improvements are needed in your business.

Whereas growing FCF hints that your company is at its peak financial performance, shrinking FCF can help you determine where you need to improve. When FCF takes a nosedive, you know that the cause is likely low operating cash flow or high capital expenditures. This means you may need to reduce your costs or increase your operational efficiency.

In addition, investors, lenders, stockholders, and shareholders tend sometimes lean toward free cash flow when evaluating businesses. This is because positive FCF can indicate that you have money available for both growth and distribution to all your stakeholders after accounting the money needed for all your operating activities. If you’re seeking financial assistance to launch your company, providing your FCF calculations is a transparent way to start.

How to Calculate Free Cash Flow

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As we hinted at earlier, the basic free cash flow formula is as follows:

FCF = Operating Cash Flow – Capital Expenditures

This formula may seem incredibly simple, but if operating cash flow isn’t already being recorded in your organization as a part of a cash flow statement, you’ll need to calculate this number before you proceed. Use the following steps to do so, referencing your company’s income statement and balance sheet as needed:

  1. Calculate your net profit by subtracting cost of goods sold, administrative expenses, and income taxes (based on your expected tax rate) from your revenue.
  2. Add back any loan amortization or depreciation charges to your net income. Depreciation can be difficult to calculate on your own, as it requires evaluating the lifespan of your equipment. If your financial statements make it unclear how much to add for depreciation, your accountant should be able to help you out, since depreciation is often calculated for tax purposes.
  3. Add net working capital from the dollar amount you get from step 2. Net working capital can be calculated by subtracting your current liabilities from your current assets. Liabilities you should include are any debts or other forms of financial obligations that you must pay back within the next year. Current assets include any assets that you expect to be sold or converted into cash within one year, including inventory you plan to sell and short-term investments.

Essentially, the formula for calculating a company’s cash flow from operations is as follows:

CFO = Net Income + Non-Cash Expenses (Depreciation and Amortization) + Net Working Capital

Once you have your operating cash flow calculated, you’ll just need to subtract the cost of capital expenditures to get your final FCF calculation.

Example of Free Cash Flow Calculation

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Sometimes, it’s easier to understand how to calculate free cash flow when you’ve seen it done. In this section, we’ll walk you through the process, so you can apply your knowledge to your business in the future.

Let’s say the following is true of a department store at your local mall:

  • Operating revenue = $800,000
  • Cost of goods sold, administrative expenses, and income taxes = $300,000
  • Non-cash expenses = $50,000
  • Net working capital = –$20,000
  • Capital expenditures = $100,000

To calculate FCF, we’d follow these steps:

  1. Subtract the cost of goods sold category from your operating revenue (800,000 – 300,000) to get $500,000.
  2. Add back non-cash expenses (500,000 + 50,000) to get $550,000.
  3. Adjust for net working capital (550,000 + –20,000) to get $530,000. Note that net working capital can be negative, if your current liabilities are greater than your current assets, which is perfectly fine.
  4. Subtract your capital expenditures (530,000 – 100,000) to get a final FCF of $430,000.

Limitations of Free Cash Flow

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Simply answering the question “What is free cash flow?” often hides the limitations that FCF has as an indicator of financial health. While FCF can successfully help you predict growth trends, it can also fluctuate and even be manipulated by business owners.

Fluctuation can occur as a natural part of business growth. Large investments in a small time frame can drastically change free cash flow, but can also rapidly boost growth in the future. For example, a clothing company can feasibly purchase a huge amount of inventory to open a large men’s clothing section, which could greatly expand the business if successful. However, this would decrease their FCF immensely since this spending is considered part of their cost of goods sold.

Manipulation of these calculations can occur both intentionally and unintentionally. This is largely because there isn’t much regulation on exactly what needs to be included in your capital expenditures, which leaves room for business owners to end up with a larger FCF. Plus, business owners can sometimes cut back on or delay certain expenditures to set up the appearance that they have a large amount of cash in a specific period.

If you want to calculate your company’s FCF, you can prevent unconscious manipulation by hiring a third-party expert to handle your free cash flow calculation. If you’re interested in investing in a business, the possibility of manipulation makes it important for you to take into account free cash flow as a trend, instead of a one-time value, as well as look at other financial indicators.

Frequently Asked Questions

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Free cash flow is a helpful part of financial analysis that many business owners overlook. To help you get the hang of this business concept, here are our answers to some frequently asked questions:

1. What types of professionals can help me calculate my free cash flow?

When you’re a startup or small business owner, it’s not uncommon for your financial records to be less organized, which makes free cash flow far more difficult to calculate. When you need assistance with this calculation, there are plenty of professionals that can help you out. We recommend contacting a financial analyst or business analyst for the best guidance.

2. How often should free cash flow be calculated?

Free cash flow isn’t something that you constantly have to calculate. Doing so as a part of your annual financial calculations is perfectly fine, though we always recommend having the number ready before pitching to investors, lenders, and any other potential stakeholders who may be interested.

3. What is considered good free cash flow?

There isn’t a specific number that makes FCF good, though generally having positive instead of negative FCF is a good sign that your company has growth potential. What’s more important to look at is your free cash flow trend over time. Having a positive trend is a sure sign that your company is actually growing.

Get Insight Into Your Business

Getting the hang of free cash flow analysis can help you understand where your business is really going. While FCF certainly isn’t the ultimate factor in determining your ability to receive a loan or get investors, it’s a tangible way to prove your success. On the other hand, it can serve as a proactive warning, so you can make business changes before it’s too late.

Ready to move on to your next lesson in corporate finance? Read our guide to learn how to calculate profit margin now.

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