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.

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!

What You Should Know about Operating Activities

Operating activities are the tasks and duties a business has to perform on an ongoing basis to earn an income. They are the core activities of a business and as a result, they affect the cash flow coming in and out, and determine the business’ net income. 

In today’s article, we’ll discuss the types of operating activities, what to include in operating activities, and how operating activities and the cash flow statement are related. 

What are the types of operating activities?

Operating activities are directly associated with a business’s various functions, such as manufacturing, selling, marketing, etc. Here are the types of operating activities:

Revenue-generating activities: Generating revenue is one of  the chief goals of a business; therefore, the majority of business activities are activities that produce income. There are two primary activities that bring revenue to the business: selling products and providing services.

Marketing and advertising activities: These types of activities refer to your business’ actions regarding the promotion and advertising of goods and services. For example, you could hire a graphic designer to create promotional labels or packages. Or, if you want to push the promotions of your products, you’d need to hire a digital marketer to run a new ad campaign. 

Administration activities: Administrative activities are tasks related to maintaining a business. These duties vary widely from workplace to workplace but most often include tasks such as purchasing materials, human resources, and basic accounting. 

Maintenance activities: Maintenance activities are carried out regularly in order to keep your office neat, tidy, and functional. These activities include cleaning, visual inspection, functional tests, lubrication, measurement of operating quantities, and oil tests. 

Customer service activities: Customer service is important to any business as it solidifies the relationship between you and your customers, which results in greater loyalty and more sales. Customer service activities include the support you provide via email, web, text message, and social media. 

What to include in operating activities?

Operating activities are directly associated with a business’ principal goal: to sell its products or services. Through operating activities, businesses are able to generate income and make a profit. Therefore, these activities relate to transactions that affect net income.

The operating activities that result in cash inflows are:

  • Cash receipts from sales
  • Sales of shares
  • Income earned from investment
  • Settlements of lawsuits and insurance claims
  • Collection of accounts receivable
  • Supplier refunds

The operating activities that result in cash outflows are:

  • Employee payments
  • Supplier payments
  • Tax payments
  • Refunds to customers
  • Settlements of fines and lawsuits
  • Interest to creditors
  • Equipment purchase
  • Interest payment on loans and dividends

Operating activities and the cash flow statement

The cash flows from operating activities are one of the most important elements of the cash flow statement. Cash from operating activities is the money generated from the business’ core operations. It is distinct from the cash flows derived from investing and financing activities. 

In contrast to cash from operating activities, cash from investing activities comes from sales and purchase of equipment and assets (tangible or intangible) and other capital expenditures. Cash from financing activities is the money your business gains from the procurement and repayment of short and long-term debt, issuance of equity, purchase/sale of treasury stock, payment of dividends, etc.

The cash flow can be either positive or negative. 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. To get an accurate picture of a company’s cash flow from operating activities, accountants add depreciation charges, losses, decreases in current assets, and increases in current liabilities to net income. 

Business managers, owners, and investors review a company’s cash flow from operating activities separately from the other two components of cash flow to see the true source of a company’s money. A positive cash flow from operating activities for a continuous period means the company is going in the right direction and thriving. This is more important than a positive cash flow from investing or financing activities, which are one-time gains from selling assets or stocks. 

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

The bottom line

Operating activities are the business’ core activities to generate income. Operating activities result in operating activities cash flow, the most important element of the cash flow statement.

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 many things such as 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.