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.

You may be also interested in: What’s Net Cash Flow and How Do You Use It?

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

You may also be interested in: Revenue vs. Profit: What’s the Difference?

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.

If you’re interested in entrepreneurship stories, business tips, or productivity tools, find more posts like this on the Shoeboxed Blog. Shoeboxed is a cloud-based software that helps businesses turn their massive paper receipts into digital data. With Shoeboxed, you can accomplish a variety of tasks: scan, store and organize receipts, manage business expenses, store business cards and even track mileage for business travelers. It’s simple to install and easy to use. Have a look at Shoeboxed now and see how it can transform how your company works.

How To Create a Business Budget with 7 Steps

Once your business is up and running, it’s essential to manage your financial performance. Establishing a business budget is the most effective way to keep your business and your money on track.

Having a business budget lets you know how much money you have, how much you’ve spent, and how much you’ll need in the future. It also can drive important business decisions.

In this article, we’ll discuss what a business budget is, why it’s important to every business, and how to create a good budget for your company. 

What is a business budget?

A business budget is a detailed spending plan that outlines how you’ll spend your money monthly or annually based on your business income and expenses.

Every penny counts! So, if you want to make the most out of your business funds, a business budget is the perfect tool, as it allows you to compare your plan with reality to see how you did. 

A business budget will help you:

  • Determine your available capital
  • Forecast your spending
  • Predict revenue

Why is a business budget important?

Why is a business budget a must-have tool for every business? Simply put, a budget assists you in determining how much money you have, how much you need to spend, and how much you need to bring in to fulfill your business objectives.

More specifically, a business budget can help your business benefit by:

  • Identifying money that is available for reinvestment
  • Predicting slow months and keeping you out of debt
  • Estimating what it will take to become profitable
  • Providing a window into the future
  • Helping you keep control of the business

How should you create a business budget?

Now that we all acknowledge the importance of a business budget, it’s time to learn how to create a good one.

A budgeting process begins with a review of your previous revenue and spending as you get started. The longer you’ve been in business, the easier this process will be because you’ll have more data to work with when creating your forward-looking budget. However, suppose your company is fresh new; chances are you may need to conduct more in-depth research on average expenditures in your sector or area to develop workable estimates for your projected finances.

Every good budget should include seven components:

1. Estimated revenue

The first step in creating a business budget is to go backward and identify all of your revenue sources. To find out how much money comes into your company on a monthly basis, add all of those income streams together. When calculating your income, make sure you look at revenue rather than profit. 

Once you’ve identified all of your income streams, calculate your monthly income. It’s critical to do this over a period of months — preferably at least the previous 12 months if you have enough data.

2. Fixed costs

The second step is to identify all of your fixed costs. Fixed costs are expenses that remain constant throughout a particular period. They’re the expenses you have to pay whether or not your company operates. For example, due to the outbreak of Covid-19, many companies are being forced to shut down their operations temporarily. Though there are no operating activities, businesses still have to pay for fixed costs such as rent and interest charges.

Fixed costs within your business might include:

  • Rent
  • Supplies
  • Debt repayment
  • Payroll
  • Depreciation of assets
  • Taxes
  • Insurance

Every business is unique, so your fixed costs will differ from those listed above. Take a few minutes to make a list of any other fixed costs that your company may have.

3. Variable costs

While looking for the information you need to identify your fixed costs, you’ll notice that your company has some variable expenses as well. Variable costs fluctuate based on how often you use a service. Many of these, such as utilities, are required for your business to operate.

Some examples of variable expenses are:

  • Raw materials
  • Inventory
  • Direct labor costs
  • Equipment replacement 
  • Office supplies
  • Utilities

4. Periodic costs

As its name suggests, this type of cost doesn’t occur monthly or annually like fixed or variable expenses. However, there are some occasions that you’ll need these expenses, so you have to be aware of this and make a budget for them. Periodic costs include education expenses, networking expenses, travel expenses, etc

5. Cash flow

Cash flow is a metric that tells you the amount of cash that comes in or goes out of your business within a specific period. This metric also represents the amount of money produced or lost by a business during a given period.

Because cash flow is the oxygen of every business, make sure you keep track of it frequently. If you have a positive net cash flow, you’re likely on the right track. On the other hand, a negative net cash flow means you may need to reevaluate your strategies. 

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6. Profit

Profit is a business’s total revenue minus total costs, expenses, and taxes. If profits are increasing, your business is expanding. Based on your predicted income, costs, and cost of goods sold, you can estimate how much profit you’ll make.

If your profit margins (the gap between income and costs) aren’t where you’d like them to be, you should reconsider your cost of goods sold and consider boosting prices. Alternatively, if you believe you can’t squeeze any more profit margin from your company, consider increasing the Advertising and Promotions item in your budget to grow overall sales.

7. A budget calculator

When it comes to business budget planning, a budget calculator can help you know exactly where you are by compiling all of your budget’s figures into a single, easy-to-understand summary. 

Create a summary page in your spreadsheet with a row for each of the budget categories listed above. This is the foundation of your budget. Then write the total amount you’ve budgeted next to each category. Finally, add a new column on the right and record the actual amounts spent in each category at the end of the period. This gives you a quick snapshot of your budget without having to dig through layers of cluttered spreadsheets.

The bottom line

A budget is a road map for your business. Though it can be daunting and time-consuming, like any good habit or practice, you will see the positive results in just a month or so. Stay diligent and continue to reach out for guidance and informative articles to help you build a financially strong and healthy business with the Shoeboxed Blog

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. Try Shoeboxed today!

How I’m Using Shoeboxed to Travel the World

Rebekah Voss is using Shoeboxed to track her expenses and do her taxes from the other side of the globe. Here’s her story about how to travel the world using Shoeboxed.

I’m sitting in an open-air café overlooking the river in Siem Reap, Cambodia. This has become my office for the month, since the option to use air conditioning at my hotbox of a hotel room costs more than the room itself.

The restaurant staff gathers around my laptop in stoic silence. Everyone holds their breath as I click the “send” button. An email rushes through the ether, journeying some 7,000 miles around the globe to land in my accountant’s inbox.

I have officially finished my taxes.

A cheer goes up from the staff, and we celebrate the happy event with pitcher (after pitcher) of Angkor beer (hey, when it’s 100+ degrees at night and the beer costs $1/pint, what else are you gonna do?)

I completed my taxes from the other side of the world without making a single phone call to my tax guy, and without a single moment of stress. How did I do it?

With Shoeboxed, that’s how.

Rebekah VossWhen I left the U.S. in November of 2013, I never imagined I’d become a digital nomad, writing and working from 16 different cities (and counting) in just five months’ time.

The world has truly become my office, and as I travel, there are only three things I need to keep my business going: a sense of humor, a strong WiFi signal, and my Shoeboxed account.

Because I’m running a business abroad but still paying taxes back home, I’m able to claim just about everything – from the cost of hotels to airfare – as a business deduction.

I’d never be able to do this without the Shoeboxed app on my phone, especially because in Asia, almost every transaction is completed in cash. I get handwritten receipts most of the time, which I immediately scan and send to my Shoeboxed account.

In the past, I’ve relied on bank statements to figure out what I’ve spent and when, but that technique doesn’t work when you’re paying in Nepalese rupees!

When it came time to do my taxes, Shoeboxed was a total life saver.

At first I was a little nervous, because I’ve always relied heavily on the Magic Envelope – I love throwing everything into the envelope and not thinking about it again until I check my account and see it’s been magically updated. It’s sort of like Shoeboxed rewards you for being lazy, which I can totally get behind.

Rebekah with hat_Vietnam_editedBut in places like Nepal and Cambodia, the mail system isn’t exactly what you’d call reliable. If I mailed a Magic Envelope full of receipts and bank statements, they might arrive, they might not. And I’d rather not play dice when it comes to my finances, y’know?

Without Shoeboxed, I would’ve had no way to give my accountant access to all of my documents in such a fast, secure way.

Since I’ve been traveling the world with Shoeboxed in my corner, I’ve launched a new travel website and published my first book.

I’m confident that I’ll continue to be able to grow my business from the other side of the planet using the Shoeboxed app to scan my receipts.

And even though I have to scan my receipts myself, I actually still carry a Magic Envelope in my backpack, sort like a good luck charm.  So far, it seems to be working.

linkedin pictureRebekah Voss is a narrative travel writer and the creator of TheHappyPassport.com, an inspiration website for solo female travelers.  She is also the author of 175 Ways to Travel Today: How to make you dream of world travel a reality right now.