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

You may also be interested in: What You Need to Know About Operating Cash Flow Ratio

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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Why Cash on Hand Is Important to Your Business?

Cash on hand is a crucial part of running a business as it influences numerous choices and decisions a business makes. If you want to run a sustainable business, you might want to consider the concept of cash on hand. In today’s article, we define what cash on hand is and its importance to a business.

What is cash on hand?

Cash on hand, also known as cash or cash equivalents (CCE), refers to the sum of all available cash a business has. This includes actual cash as well as accessible balances in checking, savings, money market assets, and other such accounts. In some cases, available credit funds may also be included.

To put it short, cash on hand doesn’t include only cash. It also comprises any liquid asset that could be quickly turned into cash—typically within 90 days. These include:

  • Money market assets
  • Marketable equity securities (stocks)
  • Marketable debt securities (bonds)
  • U.S. Treasuries assets
  • Mutual funds
  • Exchange-traded funds (ETFs)

The key distinction between cash on hand and other sorts of assets is the immediacy of access. In general, it isn’t necessary for the funds to be  physically present on the premises to be considered “on hand.” As long as the business has access within an immediate time frame, the funds are considered part of this category.

Four situations in which cash on hand is needed

Cash on hand is important to any business because it can mitigate risk and come in handy in a variety of situations. We discuss the major ones below. 

Cover expenses on time

Expenses are a necessary part of any business because they are the costs required to run a business. Expenses range from office rents and utility bills to marketing or sales campaigns budgets. 

Let’s say the utility bill is due on the 18th of the month. It’s the 15th, and you haven’t collected enough payments from your clients for some reason. It seems like you have to use extra business funds to cover this expense. 

Unfortunately, funds are already allocated to different uses or purposes, and there are no “spare” funds you could use. If you miss this payment, you’ll be charged a late fee. More importantly, your service may be switched off, and it’ll cause disruption to your business activities. 

Having cash on hand ensures you always have enough available cash or credit to cover expenses at all times and to avoid any unnecessary late fees. Additionally, you should always have an adequate contingency fund so that unexpected, urgent expenses can be paid without interrupting business activities. 

You might be also interested in: 5 Tips to Control Your Business’ Expenses

Reduce transaction costs

Transaction costs are fees incurred when you pay for a product or service through a gateway. If non-cash payments are your main payment option, chances are your business will have to pay a large amount of transaction fees. 

For small businesses or startups, it’s important to keep expenses as low as possible. One way to achieve this is by cutting out unnecessary or undesirable expenses such as payment processing fees from wire transfers, credit/debit cards, or gateways. 

However, when non-cash payments are becoming increasingly the norm in today’s world, it’s impossible for a business to stay completely cash-only. But you can at least lower payment processing fees by:

  • Choosing a low-fee payment processing system
  • Factoring these fees into your pricing
  • Negotiating lower fees
  • Accepting multiple forms of payments to balance out these fees

See more: Business Transaction: Definition, Types, And Example.

Survive an economic downturn

The COVID-19 pandemic has affected day-to-day life and has slowed down the global economy. It’s reported that over 200,000 businesses in the U.S. had to shut down their operations permanently due to the pandemic. 

If your business can survive this dark time and be able to reopen, not only will you have to adjust many of your business operation activities but also follow requirements to adapt to the new conditions. Organizations like the CDC issue such requirements to help businesses and their employees prevent exposure and infection of the Covid-19, for example, cleaning and sanitizing the facility, adding a new ventilation system, or plexiglass partitions. 

Having money on hand might be a lifesaver during these trying times. It’ll assist you in adapting to the “new normal” without going into debt.

Scale the business

Expanding your business may help you increase your customer base, improve sales, and most importantly, get higher profits. But scaling up a business requires both much harder work and lots of investment. 

When upscaling your business, you’ll have to invest in new technology and/or recruit new people. Technology, including software and machines, are frequently one-time purchases. So, rather than taking out a loan or a line of credit and having to pay interest for years, it makes more sense to use your current assets.

Sometimes, your business can grow bigger by acquiring another business. Mergers and acquisitions have become a popular business strategy for companies looking to expand into new markets or territories, gain a competitive edge, or acquire new technologies and skillsets. This sometimes appears to happen overnight. Without having immediate access to the funds to acquire a valuable business, you might miss out on a great opportunity.

The bottom line

Cash on hand refers to a business’s funds that can be used immediately. It comprises cash, any accessible balances in checking, savings, money market and liquid assets. Cash on hand is important to any business because it ensures there will be enough funds to cover expenses, survive an economic downturn or even scale a business.


If you’re interested in entrepreneurship stories, business tips, or productivity tools, find more posts like this on Shoeboxed. Shoeboxed is a cloud-based software that helps businesses turn their piles of paper receipts into digital data. With Shoeboxed, you can do tasks such as scan, store, and organize receipts, manage business expenses, and even track mileage for business travelers. It’s simple to install and easy to use.