Free cash flow, often abbreviated to FCF, measures the amount of cash a company generates in any given period.
The free cash flow formula is calculated as operating income minus capital expenses. It can be used to determine whether a company has sufficient funds to cover its short-term financial obligations or if it needs to look for external financing sources.
Since fulfilling short-term financial obligations is critical to keeping any business afloat, companies should regularly monitor their free cash flow by utilizing free cash flow formulas.
So, if you want to learn how to calculate free cash flow for your business, the following information is for you.
What is free cash flow FCF?
It is stated that: "In corporate finance, free cash flow or free cash flow to firm is the amount by which a business's operating cash flow exceeds its working capital needs and expenditures on fixed assets".
In other words, free cash flow refers to how much money a company has left over after accounting for all its expenses, including operating capital costs such as salaries and equipment costs, as well as capital expenses like investments in new projects or paying off debt. A business's free cash flow also highlights how much cash is available for paying dividends and repaying creditors.
Collecting cash and making the required investments that your business needs is important. But it counts for very little if your cash flow statements fail to show a consistent free cash flow. Calculating FCFC and net working capital (current assets minus current liabilities) is used to see where the company stands and where it is headed.
A positive free cash flow figure highlights that the business is currently generating more cash than is needed to cover its operating costs. Conversely, a negative free cash flow figure shows that the business has no money left over after satisfying the overheads for its operating activities within the financial period. It could be an indicator of poor financial health, although plenty of additional explanations are possible.
When businesses calculate free cash flow, they may also want to break it down further into levered free cash flow (LFCF) and unlevered free cash flow (UFCF). The former will calculate free cash flow after debt payments have been made while the latter is pre-debt payments.
Free cash flow FCF differs from the net figure of income because it accounts for working capital changes and the purchase of capital goods. It also accounts for any interest expense incurred for borrowed funds. Meanwhile, net operating profit is a term that determines a company's profit after expenses - excluding debt, taxes, and a small number of one-off operating costs.
Why is calculating free cash flow important?
A healthy free cash flow figure highlights that the company's financial health is currently on strong ground and highlights the potential for future growth and business expansion. Furthermore, free cash flows will be analyzed by investors and other relevant parties when determining the value of the company.
In addition to highlighting cash inflows and sales revenue, the free cash flow FCF figure takes capital expenditure into account. By subtracting current liabilities from the cash generated figure, businesses can produce an accurate financial statement that identifies current performance levels.
Generally, free cash flow is calculated on an annual basis via an annual cash flow statement. However, it can also be calculated on a quarterly or monthly basis. There are several reasons you might choose to calculate free cash flow on a quarterly or monthly basis, including:
- To better track changes in CFC over the short term - Tacking changes over a specific period can provide helpful information about whether a business is growing or shrinking. it gives you a far better understanding of your ongoing operating capital and non cash working capital (operating capital that isn't liquid cash) demands.
- To compare the current quarter or month to previous ones - This can help identify potential areas of concern, such as declines in revenue or increased capital spending. it is one way how free cash flow can highlight the need to generate cash or alter your operating activities
- To provide a more realistic view of cash flow - Some businesses may experience significant one-time expenses that may not represent their actual cash flow over an extended period.
- More accurate financial predictions - Comparing free cash flow to actual spending and income allows you to forecast future performance better. This can be used to plan for future investments or budgeting decisions by considering the long-term implications.
- To better understand customer spending trends - By looking at the year-over-year revenue changes, you can better understand how customers are responding to your offerings, helping you make better decisions about product development and marketing efforts. In turn, this can help boost sales revenue to create a rising cash flow.
- To assess how well-capitalized a business is relative to its size and company's industry - If a company has a solid free cash flow close to its balance sheet, this can indicate that it is well-positioned to handle any financial issues that may arise.
There are numerous reasons to assess financial performance, and the benefits of doing so are far-reaching. When a company pays attention to its free cash flow on a more frequent basis, it will promote accurate accounting and help you make better short-term decisions while simultaneously providing valuable insights to shape future decisions as you expand operations or take on more employees.
Whether evaluating a potential investment or making decisions about operations, understanding financial performance is crucial to success. Reviewing your company's financial data will provide invaluable knowledge that can be used to create a strong foundation for long-term growth.
What is the free cash flow formula?
Accounting software can be used to calculate FCF with ease. However, knowing how to calculate free cash flow and prepare a cash flow statement is a hugely beneficial skill for business owners.
The free cash flow formula calculates the amount of cash a company has available for activities unrelated to its core operations.
The formula is calculated by subtracting capital expenditures from operating cash flow and adding non-cash items, such as depreciation and amortization.
To work out your free cash flow, you'll first need to work out your operating cash flow. Your operational flow is the money that comes into your business through sales and other activities minus any operational expenses.
The formula for operating cash flow is generally expressed as follows:
Operating cash flow = net income + non-cash items + changes in working capital
There are several other terms, such as 'net income', that you'll need to understand how to calculate to work out your free cash flow, so let's look at them.
Net income
This is the amount a company earns after subtracting all its expenses, including taxes and other charges. It's also known as net profits or the 'bottom line'. To work out this figure, you must take your total revenue and subtract all of your company's expenses for the period.
Non-cash items
Non-cash items include depreciation and amortization, which are costs associated with assets such as buildings and equipment spread out over several years. If the asset is used for core business activities, they are classed as operating expenses.
Changes in working capital
Changes in working capital refer to the difference between a company's current assets (cash, accounts receivable, inventory) and its current liabilities (accounts payable).
A positive change in working capital indicates that more cash was used to pay down debt or purchase new assets, while a negative working capital suggests that a company has spent more money than it received in cash.
Using operating cash flow to work out free cash flow
Once you know your operational cash flow, you can use this number to work out the free cash flow.
Free cash flow is calculated by subtracting capital expenditures (such as investments in new equipment or buildings) from operating cash flow.
Before making the calculation, it is important to calculate the net investment figure - which is the total capital expenditure on current assets minus the cost of depreciation.
To calculate free cash flow, you must use the following formula:
Free cash flow = operating cash flow – capital expenditures
Once calculated, the free cash flow formula indicates how much money a company has available after it pays for its operations and investments. It's an essential indicator of a business's financial health, as free cash flow can be used to invest in growth initiatives, pay down debt, or return money to shareholders through dividends.
Meanwhile, consistent free cash flow growth over several months or years highlights the company's stability.
What is the difference between free cash flow, net income, and EBITDA?
On the face of it, free cash flow, the bottom line, and EBITDA can seem like the same thing. They each measure different aspects of a company's financial performance.
- FCF - Free cash flow measures the amount of cash a business has left over after accounting for all operating and capital expenditure. At the same time, net income is simply the total profit or loss reported on the bottom line of a company's income statement.
- Net income - Net income cash is the most common measure of a company's profitability and can be calculated by subtracting operating expenses and taxes from total revenue. It appears on the retained earnings line of the balance sheet and is a key feature of any company's financial statements.
- EBITDA - EBITDA, on the other hand, stands for Earnings Before Interest, Taxes, Depreciation and Amortization and measures a company's profitability without accounting for non-cash expenses such as depreciation. EBITDA can be useful for comparing different companies' performances over time. - Depreciation means the reduction in the value of an asset due to usage or the passage of time. - Amortization is the gradual repayment of a loan over a certain period. This figure is also necessary for calculating net operating profit after tax (NOPAT), which is the company's potential cash earnings if it had no debt.
Calculating free cash flow alongside the other financial performance figures will provide the most accurate insight into the company's financial situation. In turn, this can highlight how much cash is left, whether you need to raise money, and what required investments can take the business to new heights.
Free cash flow example
Now that you know how to use the free cash flow formula, let's take a look at an example:
Cash flows can be calculated with just three key figures - the bottom line, total of depreciation and amortization, and capital expenditure. A company has the following data for its most recent fiscal year:
- Net income: $50 million
- Depreciation & Amortization: $20 million
- Capital Expenditures: $30 million
In this example, the company's free cash flow would be calculated as follows:
Free cash flow = operating cash flow – capital expenditures
= (net income + depreciation & amortization) – capital expenditures
= ($50 million + $20 million) – $30 million
= $40 million
Therefore, the company's free cash flow is calculated to be $40 million. This indicates that, after all expenses are paid, the company still has $40 million left to pay dividends, buy back shares, or invest in new projects and capital assets. This net cash figure of cash minus liabilities is a valuable measure of financial health and performance.
How Chaser can help
Cash flow is critical to financial health and performance and vital to running a successful business. However, as the Chaser late payments report shows, companies worldwide struggle with late customer payments. Such delays can have a devastating effect on cash flow and impede business operations.
Chaser's software makes it easy to stay on top of customer invoices and get paid faster. The software automates payment reminders, so you never miss a payment again. It also integrates with accounting systems, making it easier for customers to make payments and for you to track your cash flow in real-time. It leads to healthier financial statements and stress-free account management.
Instead of being robotic, Chaser's payment reminders can be edited to reflect your brand and relationship with the specific customers you're working with. Chaser's friendly, conversational, professional style helps to build trust and make it easier for customers to pay on time.
Chaser also has advanced analytics capabilities, so you can better understand customer payment trends and anticipate cash flow issues before they occur. This allows businesses to identify opportunities to increase their income while building more secure, reliable relationships with their customers.
With data-driven insights, companies can better plan their expenses and optimize their cash flow.
