Free Cash Flow: What It Is and How It Works

If you want to know your business’ profitability, look at the net income in the income statement. But having a profit doesn’t necessarily mean you have enough cash available to use. 

That’s when free cash flow (FCF) comes in. Though some may confuse between “cash flow” and “free cash flow” because of the names, they are actually different. The former refers to the net cash inflow of operating, investing, and financing activities of the business. The latter shows the present value of the business.

Free cash flow is the amount of cash available for a business to use after paying for operating expenses and capital expenditures. This is a metric business owners and investors use to measure a company’s financial health. In this article, we’ll discuss what FCF is, its benefits to your business and how to calculate it using different methods.

What is free cash flow?

Free cash flow refers to the money a business generates after accounting for cash outflows to support operations and maintain its capital assets. In other words, it’s the money your business has left after paying for its operational and capital expenses, including payroll, rent, taxes, etc. Businesses can use FCF as it pleases.

This is also an essential metric that reveals a business’s cash generation efficiency. So when it comes to measuring a business’s profitability, many investors prefer to use FCF (or FCF per share) rather than earnings (or earnings per share).

Free cash flow also informs investors if a business has enough fund to pay dividends or buy back shares. The more FCF a company has, the higher possibility a business will be able to pay down debt and pursue opportunities, which makes it a more attractive choice for investors. 

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What are the benefits of free cash flow?

The benefit of free cash flow is that it can be used as a tool to analyze your business. Since FCF accounts for changes in working capital, it provides important insights into the value of a business and the health of its fundamental trends. For example, a decrease in accounts payable (outflow) indicates that vendors demand quicker payment. In contrast, a decline in accounts receivable (inflow) suggests that the business is collecting money from clients more quickly.

Free cash flow can also be used as a starting point for potential investors and lenders to determine if a business will be able to pay dividends or interest as predicted. If the business’s debt payments are subtracted from free cash flow to the firm, lenders and investors will have a better idea of the quality of cash flows available for additional borrowings. Similarly, shareholders will be able to examine the stability of future dividend payments by subtracting free cash flow from interest payments.

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How can you calculate free cash flow?

There are three different methods to calculate FCF that can be applied to businesses of different sizes and industries. Regardless of which method is used, the final number should be the same. To calculate FCF, businesses can use operating cash flow, sales revenue, and net operating profits.

Using operating cash flow

The simplest and most frequently used method to calculate FCF is to use the income statement and find the numerical value of the operating cash flow and capital expenditures. Operating cash flow (or net cash from operating activities) denotes the money a business makes from its core operations. On the other hand, capital expenditures represent investments of capital that a company makes to maintain or expand its business. Capital expenditures can also be found on the cash flow statement in the investing activities section.

To calculate FCF, subtract capital expenditures from the operating cash flow.

Free cash flow = operating cash flow – capital expenditures

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Using sales revenue

The second method to calculate FCF is associated with sales revenue. Using sales revenue focuses on the income generated by a business’s operation and then deducts the costs involved with that revenue. The income statement and balance sheet are used as the information sources in this method.

To calculate FCF, start with sales or revenue on the income statement, then remove taxes, all operational costs, including the cost of goods sold (COGS) and selling, general, and administrative costs (SG&A), and the net investment in operating capital.

Free cash flow = sales revenue – (operating costs + taxes) – required investments in operating capital

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Using net operating profit

Aside from using operating cash flow and sales revenue to calculate FCF, businesses also use net operating profit as an alternative method. In this method, FCF is calculated by subtracting net investment in operating capital from net operating profit after taxes.

Free cash flow = net operating profit after taxes ? net investment in operating capital

The bottom line

Free cash flow is one important metric that top-tier business persons and investors use to analyze the health of a company. It denotes how much money is left over for other purposes after operational and capital expenses have been deducted. In other words, the higher a business’s free cash flow, the healthier it is, and the more likely it is to pay dividends, pay down debt, and contribute to growth.

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