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

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.

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.

What Is a Cash Flow Statement and Why Is It Important to a Business?

As a manager or business owner, it’s important to know whether or not your business is making a profit. For this, most people usually refer to their income statements. But having a profit doesn’t necessarily mean you have enough cash on hand to pay for immediate expenses.

That’s when the cash flow statement comes in. A cash flow statement is a powerful tool to track your business’s cash inflows and outflows. In addition, it lets you know the money that is available for your business at a certain time. In today’s article, we’ll walk you through the most essential things you need to know about a cash flow statement. 

What is a cash flow statement?

The cash flow statement is a financial statement that outlines the amount of cash and cash equivalents entering and leaving a business in a given period of time. It’s one of the three most important financial documents, along with the income statement and balance sheet.

Much like the income statement, the cash flow statement measures a company’s performance over a given time. However, while income statements are helpful in determining your company earnings, spending, and profitability, they don’t always indicate how much cash you have on hand.

Instead, the cash flow statement adds adjustments to the data on the income statement, so you can see your net cash flow—the exact amount of cash you have on hand for that period.

For example, a depreciation expense, which is recorded as a monthly expense on the income statement, doesn’t have an actual cash outflow associated with it. It’s basically an allocation of the cost of an asset over its useful life. You’ve already paid for the asset you’re depreciating. Now you’re just keeping track of it on a monthly basis to see how much it costs you each month. Each business has some flexibility in selecting its depreciation method, which affects the depreciation expense reported on the income statement.

Read also: What’s Net Cash Flow and How Do You Use It?

Structure of a cash flow statement

The three main sections of the cash flow statement are cash from operating activities, investing activities, and financing activities. 

Cash from operating activities: This source denotes how much money a company makes from its core operations. 

These operating activities might include:

  • Receipts from sales of goods and services
  • Interest payments
  • Income tax payments
  • Payments made to suppliers of goods and services used in production
  • Salary and wage payments to employees
  • Rent payments
  • Any other type of operating expenses

Cash from investing activities: This is the cash generated from the sales and purchases of equipment and assets (tangible or intangible), loans paid to suppliers or received from consumers, and any payments related to a merger or acquisition. In a nutshell, changes in equipment, assets, or investments are related to the cash generated by investing activities. 

Cash from financing activities: This type of cash comes from investors or banks, as well as the uses of cash delivered to shareholders. Short and long-term debt, issuance of equity, purchase/sale of treasury stock, payment of dividends, etc., are included in this category. 

How do you calculate cash flow?

There are two formulas to calculate your cash flow: the direct method and the indirect method.

The direct method

The direct method for calculating cash flow is based on cash accounting information. This method measures the funds that come in, mainly from sales, and the money that goes out, which are usually payments to suppliers. Thanks to its simplicity, small companies often use this method to calculate their cash flow.

The indirect method

In contrast to small businesses, big companies adopt accrual accounting as their main accounting method. Under accrual accounting, transactions are recorded when they are incurred rather than awaiting payment. This means a purchase or expense is recorded as a transaction even though the funds are not received or bills are not paid immediately.

This causes a mismatch between net income and actual cash flow because not all transactions on the income statement involve actual cash items (for example, depreciation expenses). Therefore, some elements must be re-evaluated regarding cash flow from operations. With the indirect method, cash flow is calculated by adding or subtracting non-cash transactions from net income. 

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

Why do you need the cash flow statement?

1. It shows your liquidity

The cash flow statement lets you know how much money you have at a specific time. As a result, in case you need to purchase an asset, you’ll know what you can afford and what you can’t.

2. It gives insight into spending activities

If you want to know how your company is spending and where your money is going, look at the cash flow statement. Cash flow statements provide a comprehensive view of a company’s payments that aren’t shown in a profit and loss statement. For example, if your business took out a loan and is paying it back, those payments will not appear on your profit and loss statement.

3. It helps you with short-term planning

When it comes to short-term planning, cash flow statements are very valuable. Using the cash flow statement, managers can predict cash flow in the near future and keep track of expenditures to accomplish particular, short-term goals. 

4. It suggests ways to increase cash inflow capability

When it comes to increasing a business’s cash inflows, people often think of generating higher revenue. But it isn’t the only option. You can improve your cash inflow by “adjusting” some expenses. For example, if a company’s employees discover that they are spending a lot of money on inventory, they could find ways to efficiently use inventory to collect receivables faster.

The bottom line

The cash flow statement is one of the three key reports, along with the income statement and balance sheet, used to determine a company’s success. The cash flow statement tracks your business’s cash inflows and outflows in a given time. 

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 massive paper receipts into digital data. With Shoeboxed, you can do many things: 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.

What’s Net Cash Flow and How Do You Use It?

If you want to know how money is being utilized within your business, you can look at your net cash flow. It depicts the cash inflows and outflows of your business in a given period. 

But how this metric is calculated? Why is it important to a business? Is it the same thing as net income? These are some commonly asked questions that you too may have about cash flow. In today’s article, we’ll walk you through it!

What is net cash flow?

Net cash flow is a metric that tells you the amount of money that comes in or goes out of your business within a specific period of time. This metric also represents the amount of money produced or lost by a business during a given period. If more cash comes in, the result would be a positive cash flow. On the other hand, your business may see a negative cash flow if more money goes out than comes in. 

Net cash flows can be found in the statement of cash flows. Alternatively, you can determine the amount by calculating the changes in cash balance stated in the balance sheet over two different periods.

Net cash flow is generated through three main activities: operating activities, investing activities, and financing activities. As a result, it’s the aggregate of cash inflows and outflows from these three activities. 

  • Cash from operating activities (CFO): This is the money generated from the business’s core operations. Cash from operating activities comprises funds from operations and changes in working capital. Funds from operations include net incomes, depreciation (an expense converted from a fixed asset as the asset is used during normal business operations), deferred taxes (taxes that are owed but are not due to be paid until a future date), and other funds. Working capital involves current assets and liabilities (accounts payable, account receivable, etc.)
  • Cash from investing activities (CFI): This is the net cash generated from sales and purchase of equipment and assets (tangible or intangible) and any other capital expenditure for core operations. It also includes the movement of cash due to investments made outside the company like investing in other businesses, stock market, etc.
  • Cash from financing activities (CFF): This is the net cash generated from the procurement and repayment of short and long-term debt, issuance of equity, purchase/sale of treasury stock, payment of dividends, etc.

See also: What You Need to Know about Operating Cash Flow Ratio

The net cash flow formula

So, how do you calculate net cash flow? Just use this formula:

Net Cash Flow = Net Cash Flow from Operating Activities + Net Cash Flow from Financing Activities + Net Cash Flow from Investing Activities

It may look complicated, but it’s really simple. Take this real-world example, for instance:  

Company A has a cash flow from operating activities of $90,000 and a cash flow from investing activities of $30,000. However, Company A also has to pay a loan repayment of $20,000, which results in a cash flow from financing activities of -$20,000. 

How can you calculate the net cash flow for Company A? Apply the formula above, and it will look like this:

Net Cash Flow = $90,000 – $20,000 + $30,000 = $100,000

This means that Company A has a $100,000 net cash flow over the given period. A positive cash flow indicates that the financial health of company A is relatively strong. They’re going on the right track, and if they keep up the good work, chances are they’ll be able to grow quickly. 

Why is net cash flow important? 

Net cash flow serves as a gauge to determine your business’ liquidity. As a result, it gives business owners like you insight into the business’s financial health. Having a positive cash flow is a good sign meaning that your business is thriving. On the other hand, having a negative cash flow might indicate that your business is facing trouble.

With that being said, sometimes, a negative cash flow isn’t necessarily a bad sign. For example, if you’ve recently invested a significant amount of money into new equipment, this could lead to a negative cash flow for a period. However, it would boost up your productivity and bring you higher revenue in the future. 

But, as a rule of thumb, positive cash flow is more likely to reflect positive business performance. Positive cash flow opens up opportunities such as being able to invest in research and development or hiring more employees. On the other hand, a negative cash flow may limit your business’s growth. Consequently, you must figure out ways to improve cash flows.  

Is net cash flow the same as net income?

Technically speaking, they aren’t the same. Net income demonstrates the effectiveness of a company’s sales and marketing, resulting in sales volume, while cash flow is more of a liquidity indicator.

Your business can have a high net income but still post a negative cash flow. This is because your income generally considers accounts receivable, but cash flow doesn’t. For example, assume you made a sale for $5,000, but you let your customer pay in 5 months. As a result, the cash flow you gained from the sale would be $1,000 for this month, whereas your income is recorded as $5,000 if your company adopts the accrual accounting method. 

How can you manage cash flow?

As we mentioned above, the net cash flow is the total cash from operating, investing, and financing activities. In contrast to investing and financing activities which may be one-time or sporadic revenue, the operating activities are core to the business and are recurring every month. As a result, this is the main source of most of a business’ money. 

So, if you want to manage your cash flow more effectively, start with cash flow from operating activities. Since cash from operating activities is mainly generated through the sales of goods or services, monitoring your transactions daily will help you better control the cash flow. 

It’s a good practice to match the cash inflow from the sales with sales receipts incurred in a day everyday. By doing so, once you identify a mistake has occurred, you can quickly take action to rectify the issue. It can be less stressful as well. 

Even if you’re a small business, you can generate scores of sales receipts per day. It could take up lots of time if you have to manually calculate all the cash transactions made in a day and cross-reference it with the actual cash you receive.  

To save your time and effort, switch to bookkeeping software that can automatically calculate and make reports out of your receipts. A great software for this is Shoeboxed. All you have to do is get your receipts scanned, stored, and organized. Shoeboxed will make a report out of it for you. 

The bottom line

Net cash flow shows you the bigger picture of your cash inflows and outflows. It lets you know how your business is doing and whether you need to make any changes to it. If you have a positive net cash flow, you’re likely on the right track. On the other hand, a negative cash flow means you may need to reevaluate your strategies.