Free cash flow represents the cash a company can generate

Free cash flow: definition, importance, and calculation

My Blog

You may find a number of metrics at your disposal to evaluate your company’s health. Cash flows stand as an important yet sometimes under-emphasized barometer. After all, your business cannot pay salaries, wages, bills, dividends, or suppliers or make investments without it. By understanding your free cash flow statement, you can determine your true ability to pay for operations, investments, and discretionary spending to enhance or move your business forward.

Free Cash Flow Defined

Free cash flow (FCF) means the cash your business creates or has after you have accounted for the cash costs of the goods sold or services rendered, paid the operating expenses and invested in your enterprise. In its simplest terms, you may consider free cash flow as the cash you generate from operations less your capital expenditures. In a free cash flow calculation, capital expenditures represent spending on assets that you expect to use for more than a year in the business. With the cash you have left after spending it on operations and investments, you can distribute the profits or have a cushion to meet future and perhaps unexpected expenses and needs.

Why Not Use Net Income?

To appreciate the benefits of measuring free cash flow, it helps to contrast FCF with principle net income and how net income is calculated. The simple formula for net income is revenues fewer expenses. However, the way your company conducts its accounting can mean that net income doesn’t accurately reflect cash flows into or out of your business.

Revenues

Revenues consist of sales, but not necessarily of the cash variety. In fact, the Generally Accepted Accounting Principles (GAAP) provide that revenues (and expenses) are counted when accrued. That means you record revenue when you have delivered the goods or services and, thus, become entitled to payment. An expense accrues when you become obligated to pay it — even if you haven’t already paid it. Many businesses, especially in the retail or service sector, receive cash at the moment of sale. Yet, since the receipt of cash is not a prerequisite to the recognition of revenues in accrual-based accounting, it is possible that revenues do not reflect available cash flows. Further, with the accrual basis of accounting comes room for interpretation over when revenue is earned. An inflow or receipt of cash happens at a definite moment and without room for interpretation.

Expenses

In the net income formula, expenses normally fall into four categories:
*Cost of Goods Sold, which can be calculated as direct labor costs plus raw materials, or more commonly, the difference in the inventory at the end of the accounting period and inventory at the beginning. The difference represents the costs of acquiring the merchandise that you sold.
*Operating Expenses, which consist of items such as utilities, rent, salaries, legal or accounting expenses, supplies for business operations and depreciation, or amortization of equipment. These expenses normally are not tied to specific items sold, but apply to the business overall. Sometimes, you may classify these as administrative expenses.
*Interest Expenses, which means the interest your business pays on mortgages or other debt.
*Taxes. These refer to the income taxes on the profits after subtracting these items. As with revenues, expenses on an income statement are not necessarily withdrawals of cash. Under the GAAP, expenses are recorded when accrued and not necessarily when paid. Further, the net income calculation incorporates two non-cash expense items: depreciation and amortization. These methods come into play with assets such as machines, vehicles, and equipment that you plan to use over a number of years. You don’t count the entire cost as an expense in the year of acquisition. Instead, you treat as an expense a portion of the cost over each year of the asset’s useful life. With amortization and depreciation, you are counting expenses at times that you have not spent money.

Net Income Under Cash Accounting

To solve some of the problems of accrual accounting, businesses may recognize revenues and expenses only when money is received or spent. This use of cash accounting eliminates discretion and uncertainty of having to decide when a company has a right to a revenue or obligation to a payment. Even with a cash accounting approach to revenues and expenses, the net income formula still includes amortization and depreciation (non-cash expenses). Also, net income (even under a cash accounting method) tells you only how much cash remains after operations. It does not account for needed or actual cash expenditures.

Why Care About Free Cash Flow?

As an initial matter, let’s deal with the concept of capital expenditures. This spending is geared toward acquiring fixed assets such as land, computers, machines, and buildings; and renovations or upgrades of existing assets. Capital expenditures allow your business to produce, move products or services, and otherwise engage in the activities that generate revenues and ultimately profits. Profits often represent robust sales which, in turn, signals increased demand for your products or services. To meet the increased demand and otherwise sustain growth, you need sufficient funds to acquire or upgrade your assets. The free cash flow formula takes into account the anticipated or actual spending on capital assets. When you subtract your capital expenditures from the cash flow that your operations generate, that difference represents the amount of cash you have left for discretionary or other spending. The free cash flow can mean different things depending on the type of stakeholder in your business. Investors see healthy levels of free cash flow as sources for dividends and other distributions of profits. These dividends represent a form of return on investments. With large free cash flow comes less of a reliance upon debt to acquire capital. Additionally, you can retire debt, or a significant portion of it, and lower your interest costs. This attracts investors and may help you obtain loans if you need it for more capital investments. You also obtain a cushion against unexpected or sudden changes in economic conditions. Prices for gas and other commodities may increase dramatically or otherwise beyond your budget. An economy in recession or with low consumer confidence may decrease sales.

The Formula

Generally, the free cash flow calculation takes the following form: *Free Cash Flow =Net Income +Non-Cash Expenses-Increases in Working Capital-Capital Expenditures

The Parts of the Formula

We have discussed net income and non-cash expenses. You add back amortization and depreciation expenses because you actually did not spend money on the expenses when you recognized them. Amortization and depreciation represent portions of the overall cost of a capital asset you have acquired.

Increases in Working Capital.

You can calculate net working capital from balance sheets. Specifically, you subtract the current liabilities from current assets. To arrive at the increase in working capital, you subtract the net working capital at the beginning of the accounting period from the net working capital at the end. You then subtract this difference from the net income and non-cash expenses.

Capital Expenditures.

In addition to subtracting actual capital expenditures, you can use the free cash flow formula to forecast or plan your needed capital expenditures. For instance, if you have in mind a particular amount of free cash flow, you plug that number as the solution to the formula and then solve for capital expenditures. Profitability certainly is an important measure of your company’s financial performance. However, net income does not fully account for capital expenditures. Following your free cash flow statement helps you gauge your company’s ability to meet both its operating and capital investment needs and the expectations of your investors and other stakeholders.

FAQ

Free cash flow – what does it mean for business growth?

Free cash flow reflects the financial performance of a given company. This is a measure that aims to match the current cash value of a business that earns after users pay all of its bills and reinvest the cashback into the business. Furthermore, this cash can be used as profits, to hire more staff, to invest in machinery, and as a chance to offer investors more money back. It also indicates the company’s ability to pay down debt, fund the dividend, get back stock, and improve business growth. However free cash flow is a terrific measure of corporate health, which is done by the method of cash flow analysis, it also has its bounds and is not resistant to tricks in a financial statement.

Generally, growing free cash flow is a mark of prosperity, while declining free cash flow may be a warning sign. Free cash flow is considered ‘free’ since this is available for finance costs. Businesses with balanced free cash flow are the ones that also attract investors season after season. In short, increased amounts of free cash flow are a positive symbol of financial wellness for an organization.

What is the difference between cash flow and free cash flow?

Two very different, cash flow and net free cash flow, are key financial indicators designed to automatically analyze the financial performance of the company. In one way or another, there can be noticeable contrasts between any of these two, which allow investors how well a company can generate cash and how it ends up spending it. When it comes to cash flow, it signifies the amount of net cash and income equivalents that are moved in and out of a company. The positive cash flow shows that liquid assets in a company are increasing, allowing it to settle debts, reinvest over its business, collect tax to board members, and pay expenses.

Cash flow is observed on the cash flow statement, where it includes three segments describing in detail operations. These three elements become operating cash flow, operating expense, and capital expenditure. When, free cash flow is the cash run by a corporation through its production manners when such outflows of cash concerning fixed capital investment including property, plant, and equipment can be deducted. Otherwise speaking, free cash flow or FCF is the money left over after a business has paid its operating and capital expenses.

Clearly, there is indeed confusion in the difference between cash flow and free cash. One is used to figure out just how much income comes into a company at the end over a year, as well as how much net cash flow goes out. The other is then used to point out the company’s valuation by using a Discounted Cash Flow (DCF) model.

What is the importance of the free cash flow?

Free cash flow is important as it helps a firm to adopt new strategies that mostly improve the value of an investor. Researching new products, dividend payments, making mergers, and reducing debt without cash is truly unfavorable. Countless investors tend to use free cash flow instead of net income to assess the financial yield also the fcf formula of business since free cash is easier to manage than net sales. As well, it is crucial to remark that negative free cash flow is not harmful to the business in its own right; it may be an indication that one company is actively investing. Moreover, it is important to keep in mind that if these investments generate a significant positive return, the strategy has the opportunity to pay for itself in the very long term. Certainly, this will further increase the positive free cash flow and furthermore the enterprise value.

What is the difference between free cash flow and net income?

Net income, as well as free cash flow, aim to calculate the very same matter. A firm can create consistent capital for its developers. The first difference is the equity purchase accounting. Net income deducts depreciation, meanwhile, the measure of free cash flow uses net capital purchases from the last stage. The second difference is that the measurement of free cash flow assists to make structural changes for reforms in the total asset, where only net income is not. In resume, the significant differentiation is further that net income contributes to forthcoming market valuation, and then for impoverished past decisions on something identified first as “non-cash expense.” Undeniably free cash flow is a measure of the actual income that can be dispersed conceivably to the owners.

Did we miss any important cash flow tips?

Focusing on optimizing payment management and reviewing operating expenses can increase cash flow. Complementarily, it may be a big idea to improve inventory management to reduce operating costs as well. Among the most effective actions required these are the next five:

  1. Meeting with all the providers: consider meeting with them to renegotiate rates, credit terms, and/or obtain discounts for larger orders, thereby reducing costs.
  2. Reassess the expenditure: re-evaluating the strategy and increasing income requires attention to interest expense that is seen as a minor point. You should take a look at your bills and decide where adjustments can be in place, even if only briefly. 
  3. Getting more efficient: efficiency is a concept that can be applied to everything. Small gestures, such as using smart technology, replacing old machines with more suitable equipment, even reorganizing jobs are decisions that can cause the business to reit or reduce its overall spending level by operating more efficiently.
  4. Standardizing billing: never lose sight of such an important cash flow issue as invoicing. By sending invoices on time and keeping due dates in mind are key aspects of good management.
  5. Facilitate payment: If you only accept one or two forms of payment, such as cash, debit card, or credit card payments, it may be time to consider adding a few more options to meet customers’ needs. By offering online payment options would greatly benefit the equity value and the cash flow by itself.