A Complete Guide To Understanding Free Cash Flow

What is Free Cash Flow?

Free cash flow enables businesses to understand profitability. This is not the same as operating cash flow because the amount of cash a business generates after capital expenses are measured. Capital expenditure includes expenses for equipment and buildings. We have discovered numerous ways to use free cash flow (FCF) such as paying our investors additional dividends, decreasing our debt, and expanding our enterprise value. Extremely small businesses are generally more concerned with basic bookkeeping, so the question of how to calculate free cash flow is usually irrelevant.

The most notable exceptions are growing businesses, companies interested in expansion, and organizations with a lot of investments. In these instances, determining the free cash flow has numerous benefits. Both the unlevered free cash flow and levered free cash flow can be calculated. The difference is the levered free cash flow determines how much cash remains once all business expenses have been paid. The unlevered free cash flow shows the remaining cash prior to paying any interest expense. The unlevered free cash flow represents the cash flow available to the business without any interest payments. This shows the financial status of the business if no debts were present.

The Importance of Free Cash Flow for Small Businesses

Despite the accounting method chosen by the business, there is an expenditure factor that must be paid including employee salaries, new factories, construction, utility bills, and dividends. This makes the ability of the business to earn cash extremely important. There are many reasons the generation of cash is critical for small businesses including:

Opportunities for Growth:

When a business is interested in investing in another business or expanding current operations, free cash flow offers many important opportunities. Small businesses can use the funds for adding more locations, hiring additional employees, or expanding the current products or services.

Financial Health:

Free cash flow measures the financial health of the business. Although we realize there are other indicators available, we believe a consistent flow of free cash is a strong indication the business will achieve stability, success, and growth.

Attracting Potential Investors:

A consistent flow of free cash is very important for both potential and current investors because it determines the exact amount of cash available for the business. This peaks the interest of investors by demonstrating the business has the ability to pay dividend, buy back stock, or decrease the current debt.

How to Calculate Free Cash Flow

Every business should be aware of how to calculate free cash flow. We are aware of several different methods, but find the easiest calculations are achieved with the most frequently used method. Free cash flow calculation begins with the income statement of the business showing the current cash flow. We take the cash flow from our business and deduct our capital expenditure to determine our free cash flow. Even though this free cash flow formula is basic, it is effective.

Free cash flow yield often has a lot of volatility. For this reason, we recommend observing the flow for several years as opposed to a single quarter or year whenever possible. A good example is a small plant manufacturing golf cart. The operating cash flow for the business on the yearly cash flow statement is $800,000. During this time, the business spent $300,000 on the development of new golf carts. The free cash flow for the business can be calculated using these figures.

The free cash flow formula begins with the sum of $800,000, then deducts $300,000 to arrive at a free cash flow of $500,000. This means the business has $500,000 available for anything from expansion to developing a new line of golf carts. There is another formula we sometimes use to calculate our free cash flow. We begin with our net income, add in depreciation, deduct capital expenditures, and any changes in our working capital to arrive at our free cash flow.

To use this free cash flow formula, we need both our balance sheet and income tax statement to find our amortization expenses, depreciation, and net income. Our next step is calculating our working capital. We accomplish this by deducting our current liabilities from our assets. We then deduct our capital expenditures to determine the free cash flow for our business.

Using Free Cash Flow to learn About the Business

A lot can be learned about a business by the free cash flow. A good flow shows the business has more than enough cash to pay the bills, with enough remaining to be used in numerous ways such as distributing to the investors. The business has the opportunity to add another business to the portfolio or complete a company expansion. The free cash flow is a good indication as to whether or not the business is in the right position for expansion.

Expansion can include hiring additional employees, acquiring another office, investing in another business, or purchasing a competitor business. The free cash flow indicates if an increase in earnings is expected. The majority of investors will not be interested in any business with poor free cash flow. This is because a good flow is a solid indication the business earnings will increase, resulting in a much better-invested capital.

Small businesses can use the free cash flow to determine if restructuring is necessary. Almost every small business we have come into contact with has suffered from a negative or poor free cash flow at some point in time. This may be an indication the business needs to restructure to increase the flow of free cash. This flow is not used by every business to measure either stability or success. If the business model does not include any type of long-term investments, there are other options.

Banks, financial institutions, and service businesses often rely on net income to determine financial performance. A manufacturing company consistently making investments in heavy equipment or factories is better off using free cash flow to determine financial performance.

How Does Depreciation Affect Cash Flow?

The cash flow of the business is not necessarily affected by depreciation. The cash flow is tax-deductible, effectively decreasing the outflow of cash required for income tax. Depreciation is classified as a non-cash expense because it is a consistent charge for fixed current assets. The idea is to decrease the cost recorded for the life of the asset. When we create a budget pertaining to our company’s free cash flow, we usually list depreciation as a decrease in our capital expenditure.

The implication is depreciation has not affected the cash flow for our business. Depreciation does cause an indirect impact on our cash flow. Every time we prepare an income tax return, one of the expenses we list is depreciation. This decreases how much taxable income we are required to report on our taxes. Since depreciation is a qualified expense for the calculation of taxable income, we are able to decrease the amount of tax owed by our business.

This means our free cash flow is affected by the depreciation in relation to the amount of taxes we pay for income tax. We are able to take advantage of this effect provided the government is accepting accelerated depreciation for increasing the depreciation we use for claiming taxable expenses. The result is decreasing the cash flow required for our tax payments even more for the short-term. This does mean we will be unable to claim as much depreciation later on.

During these latter periods, we do not have as much depreciation to claim. The only reason depreciation exists is the association with our fixed assets. When we initially purchased out fixed assets, we required free cash flow to make the payments necessary. Since a fixed asset requires an underlying payment, the positive impact of the depreciation regarding our free cash flow becomes null and void.

Reasons Why Calculating Free Cash Flow is Important

Since fcf yield is the business inflow once all of the normal business expenses have been paid, the business has a much more accurate and clearer idea of how much profit can be generated. If the cost of providing a product or service is not determined accurately, the financial model will not be sustainable. To be able to understand how much capital asset the business has available for reinvestment, the free cash flow must be determined. Not only is this important for business sales growth, but for all of the following as well.

Lenders:

Lenders are interested in ROI because they want to get their investment back in addition to interest. Unless the business is profitable, there will not be funds available for paying the loans.

Investors:

Investors want to make a profit. If the business is not generating a profit margin, the ROI is going to be poor.

Business Partners:

A good free cash flow is necessary for attracting a business partner. This is how the viability of the business is determined.

Creditors:

When a small business opens a line of credit, the metrics of the free cash flow are used for determining business legitimacy, and the ability to repay all debts on time.

FAQ

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

It doesn’t matter the size, growth rate, or culture of the company we are running. In the business world, every organization has a cash requirement that will make our business run smoothly. If cash is not present, the probable consequences are that the company will not be able to meet its obligations in the short or long term, as a direct result of which it will go bankrupt. The two types of cash flows can be cash flow and free cash flow. Cash flow refers to the inflow and cash outflow to/from the organization. On the other side, free cash flow, as the name indicates, is the cash available in the company. We can summarize that:

  • Cash Flow reveals the company’s solvency, in contrast to Free Cash Flow which reveals the company’s overall performance.
  • Cash flow is calculated by the sum of net operating profit, investment,  financing practices. Free Cash Flow uses only the cash from operating activities for its own calculation.

Is cash flow same as profit?

The cash flow and the profit are two different financial parameters that every entrepreneur must follow in the financial environment. The availability of cash is capable of bankrupting or maintaining a business, it all depends on its management. For example, a business with poor cash flow and a high profit might make it difficult to pay bills, since the liquidity needs to be fluid. The idea is to be parallel and not spend too much on the reinvestment of profits since a reserve can be made, it does not make sense to have very high profits with bad management of the net cash flow.

Why is free cash flow negative?

Actually, free cash flow is only a negative free cash flow (FCF) when it is mismanaged. With bad management of it, instability can be found and affects the company, which can destabilize the net working capital and it would not be used as it should. Nevertheless, when a company is generating more cash than is needed for management and is reinvested to grow the business, it makes it clear it is not “negative fcf” anymore but means is now positive. In contrast, mismanagement of free cash flow reveals that a company does not generate enough to support the business. One way to avoid this is by extending payments, adjusting collection policies, and depleting inventories.

How do you maximize cash flow?

It is vital to balance the short and long term needs of our business. To ensure short-term health, the best advice is to have a substantial cash balance on hand in an account, along with loans and credit lines in case it is needed. But in the long run, it could be an impediment to the growth of a business. Over-cash could easily be put to a better resolution, for example by investing in new equipment for our business, spending money on publicity and marketing, and also paying off debts. By learning how to forecast cash flows adequately and manage them efficiently, we can maintain a proper amount of cash at all times using forecasting tools. Most importantly, managers can take steps to avoid a potential cash flow dilemma before it becomes a crisis that threatens the future of their business. Consequently, through good cash flow management, the top perspective can be found between the short term and the long term.

Why is free cash flow important?

A company’s financial prosperity depends on its cash flow. Therefore, it is imperative to elaborate and properly interpret the cash flow, since it will allow us to operate in the most appropriate way in any risky scenario. This is the tool that can best position businesspeople in the present and that makes it possible to make the best projections concerning future income and an operating expense. If there is a cash overflow, we will be able to make decisions adjusted to our business real situation or anticipate the lack of liquidity at a given moment. Furthermore, the cash flow will allow us to determine if it is appropriate to net borrowing at the moment or not.