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

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.

Checkout Conversion Rate: What Is It? And How Can Online Businesses Improve It?

Income is the bloodline of every online store. There are many factors that influence an e-business’s profitability. Today we will introduce you to an element that has a great impact on your business: checkout conversion rate.

Let’s say that your online store has hundreds of visits per week, but only a few of them make a purchase. How can you persuade more of your visitors to buy your products? Read on to find out what checkout conversion rate is and strategies to improve eCommerce conversion rate. 

What is a checkout conversion rate?

The checkout conversion rate is an important metric for every e-commerce business to follow. It refers to the percentage of customers that start and finish the checkout process in a particular amount of time. 

Online businesses can monitor patterns and inconsistencies by tracking conversion rates on their checkout page over time. With this approach, e-businesses will be able to learn more about which components of the checkout experience resonate with their consumers and which might be improved. As a result, a slight improvement in checkout conversion rate can substantially increase income.

Shopping cart abandonment is directly linked to e-commerce checkout conversion rates. This represents the percentage of consumers who add products to their shopping cart but never finish the transaction. We’ll learn more about shopping cart abandonment in the next section.

Why do customers abandon their shopping cart?

Cart abandonment is a common issue. For one reason or another, customers often leave an e-commerce site without making a purchase, even when they’ve put goods in their cart. According to research company Baymard Institute, the average cart abandonment rate is 68.8%, which means that nearly seven out of ten customers have put items in their cart but don’t finish the transaction. 

Here are some common reasons:

  • High extra costs (shipping, tax, fees, etc.) 
  • Too much information required
  • Slow delivery time
  • Complex checkout process
  • Lack of trust in website security
  • Want to save the items for later
  • Lack of preferred payment option
Reasons for shopping cart abandonment ( Source: Baymard)

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4 strategies to improve checkout conversion rate

  1. Convert to a single-page checkout process

The checkout procedure should be as quick and smooth as possible for your customers. People are busy, and whatever you can do to save them time and speed up the process will help you secure a sale.

This is when a one-page checkout comes in handy. Here are some benefits a single-page checkout process offers: 

  • It’s shorter and gives customers an incentive to complete the transaction.
  • It has all the fields on the same page, avoiding unnecessary complications for users.
  • It requires fewer clicks. Behavioral research shows that the fewer the number of clicks required to complete an action, the higher the conversion rate.
  • It reduces the chance of website errors occurring between one checkout page to the next. 

The famous hypermarket Walmart has an excellent single-page checkout. It has a 3-step process with each step including a minimal form that is easier to navigate. 

Walmart single-page checkout (Image source: Ecommercebooth)
  1. Skip the mandatory sign-up

Due to the fear of personal data being leaked or tracked, online shoppers are becoming increasingly hesitant to provide their personal information to your website. Though customers may enjoy your items enough to purchase them, only a small percentage of them want to register an account right at the start of their buying journey.

Despite this, many e-commerce businesses continue to force their potential buyers to create an account for user information collection and to send newsletters. Rather than being excited to take advantage of a newsletter with deals and promotions, this forced account creation may actually lead to prospective customers giving up on buying altogether.

If you’re concerned that you won’t be able to develop a user database without mandatory sign-ups, keep in mind that you can always request a buyer’s contact information during the checkout process. The essential thing is that you give them an option, not an obligation.

If customers had a good shopping experience, they’ll come back and realize the value of having an account. You can also send them emails to encourage them to join your program.

  1. Offer free shipping

The delivery fee is one of the most common reasons for online shoppers to abandon their shopping carts. Customers visit a store and put items into a cart, but at the end of the checkout process, if they discover that they don’t qualify for free delivery or that the fees are too high, they will ditch the deal. 

Free shipping is what most online shoppers value. Shoppers are thrilled when they find a good deal and will take advantage of every opportunity to save a few dollars. Therefore, though it involves a cost for online businesses, offering free shipping significantly boosts eCommerce conversion rates. Besides, it’s not too difficult to calculate and work in the price of shipping into the product price

  1. Use shopping cart recovery emails

Sometimes, all it takes to bring back a customer to your site and entice them to complete their purchase is a little push. Enter shopping cart recovery emails. These shopping cart recovery emails are emails sent to a visitor who has abandoned the checkout process halfway through with the promise of a special deal or promotion for them to close the purchase.

Shopping cart recovery emails are incredibly successful. According to statistics, 46.1 percent of all such emails are opened (the mean open rate for all emails varies from 10-25 percent across industries). One out of every eight of these emails is clicked, and a third of those clicks result in a sale.

To get the most out of a shopping cart recovery email, online businesses should tap the customer when the lead is still “warm.” Typically these emails are sent 1-3 hours after the abandonment when your brand and your product is still fresh in the visitor’s mind. One important note is that you should check the items they’re interested in are still in stock before sending out these emails.

The bottom line

To every online business, the checkout conversion rate is a key metric that affects their ability to turn visitors into customers and close sales. That explains why e-businesses always look for methods to improve this point. For those looking for tactics to increase checkout conversion rate, following the advice you read in this article will be just what you need.

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 Gross Profit and How Do You Calculate Gross Profit for Your Business?

The gross profit metric shows a business’s profit based on its revenue and cost of goods sold. By knowing the exact figure of your business’s gross profit, you will gain a deep insight into your operational efficiency and financial performance, allowing you to take immediate action to improve. 

This article will give you a simple explanation of what gross profit means and a quick guide on how to calculate it correctly. 

What is Gross Profit?

A business’s gross profit is the difference between its sales revenue and the cost of goods sold (COGS). Gross profit reflects how much the company actually earns from selling its products and/or services. 

Gross profit appears on the company’s income statement and it can also be referred to as gross income or sales profit. 

How to Calculate Gross Profit 

To calculate gross profit, subtract the cost of goods sold (COGS) from the total amount brought in from sales. 

The formula for Gross Profit 

Gross profit = Revenue – COGS 

Now, let’s take a closer look into the two factors that make up gross profit: 

  • Revenue: the money generated from the total sales of your products or services. Revenue represents your gross income before deducting any expenses and taxes. Note, some companies may substitute net sales for total revenue when computing gross profit. Essentially, net sales are the same as total revenue, except it deducts the price of refunded or returned sales, allowances, and discounts, if any. 

See also: Revenue Vs. Profit: What’s the Difference?

  • Cost of Goods Sold (COGS): includes all of the direct costs and expenses involved in producing, selling, or delivering your goods and services. Here are some typical examples of COGS:
  • Raw materials 
  • Direct labor costs in production 
  • Shipping fees 
  • Utilities in production    
  • Product packaging fees 

COGS excludes indirect costs and fixed costs, such as rent, office expenses, salaries for administration staff, depreciation, advertising, etc. 

Example of How to Calculate Gross Profit 

Below is the income statement of ABC Inc: 

Revenues$ (million) 
Sales 120,000
Financial services10,000
    Total revenues130,000
Expenses  
Cost of sales95,000
Administrative and other expenses10,000
Financial services operating and other expenses8,000
    Total expenses113,00

To calculate the company’s gross profit, we first have to determine the cost of goods sold, which is $95,000 in this example. Remember, do not include administrative, operating, or other expenses as they are not directly involved in making the products. Next, we calculate how much our total revenue is, which comes to $130,000 in the example. 

Based on those figures, we subtract the cost of goods sold from revenue to work out the gross profit: $130,000 – $95,000 = $ 35,000.

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How Can the Gross Profit Metric Help Your Business? 

Gross profit is one of many basic accounting and financial tools available for small businesses. It focuses on one simple fact: the higher your revenue and the lower your production costs are, the greater your gross profit is. By knowing the exact number of your business’s gross profit, you will have a sound idea of whether the production process could or should be more cost-efficient. 

You can then look for effective solutions and take immediate measures to maximize your gross income. For example, if you notice that manufacturing costs are too close to or exceed your revenue, try different cost-effective methods to lower COGS by switching to a cheaper supplier or reducing your packaging weights. Alternatively, you can also try to boost sales by stepping up your marketing campaigns. 

The Limitations of Gross Profit

The gross profit metric’s major flaw is that it doesn’t account for all of a company’s expenses and income sources, so it’s not really useful when it comes to analyzing real profitability. 

Another point is that the gross profit metric is a fixed number unique to your company – you can’t use it to compare with your competitors. For example, it wouldn’t make sense or bring any useful insights if you compared the gross profit figures of a newly established startup with an established company in the industry. 

Instead, to compare, you should compute the gross profit margin – a financial ratio that shows how well a company makes income relative to how well it manages its manufacturing costs. You can then use this ratio to compare against other companies as gross margin percentages are all depressed in proportion to the magnitude of each company’s sales and COGS. 

Formula for gross profit margin (GPM):  

GPM = Gross Profit/Revenue

Final thoughts 

Gross profit is a useful and easy-to-calculate metric that allows businesses to understand their financial performance on a deeper level, resulting in greater profits. However, to see the broader picture of your business’s efficiency, it’s best to analyze and use the gross profit metric with other financial ratios as well. 

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