Free Cash Flow 101: What it Means & How to Calculate it

Free Cash Flow 101: What It Means & How to Calculate It

What Is Free Cash Flow?

Free cash flow (FCF) is a way to measure a business’ financial performance and health. It’s the cash that a business has left over after accounting for capital expenditures and operational expenses. (Capital expenditures are funds used by a business to acquire, upgrade and maintain physical assets such as property, buildings or equipment.)

The presence of FCF will indicate that your business has cash to expand, develop new products, pay dividends, reduce debt and more. High or increasing cash flow is often a sign of a healthy business that is succeeding in its current capacity.

FCF is a measurement of a business’ ability to generate cash, which is one basis for stock pricing. In fact, some investors tend to value FCF more than most any other financial measurements. FCF has a direct impact on the worth of a business, and investors often look for businesses that have a high or increasing FCF paired with an undervalued share price. Typically, this disparity means the share price will increase soon.

Free Cash Flow vs. Net Cash Flow

It’s important to understand how FCF differs from net cash flow. Net cash flow is known as the “change in cash and cash equivalents.” It’s the difference between a business’ cash inflows and outflows in a given period, and it can be found on the business’ cash flow statement. Meanwhile, FCF measures a business’ financial performance, calculated as the difference between cash flow and capital expenditures.

Two Types of Cash Flow

As a reference, there are two types of FCF: free cash flow for the firm (FCFF) and free cash flow to equity (FCFE). FCFF is a measurement of a company’s profitability after all expenses and reinvestments. FCFE is a measure of how much cash is available to the equity shareholders of a company after all expenses, reinvestment and debts are paid. It is essentially a measurement of equity capital usage. This post will be based on the use of FCFF.

How to Calculate Free Cash Flow

FCF is what your business has leftover at the end of the year or quarter after you pay your expenses and new capital expenditures. So how do you calculate it?

There are three different formulas, which are all relatively simple. As you go through these three equations, all methods of calculating free cash flow will come to the same answer, since they approach the same information from different viewpoints.

Referring to a balance sheet example can help you visualize these equations.

Free Cash Flow Formula 1:

Free Cash Flow = Sales Revenues – Operating Costs and Taxes – Required Investments in Operating Capital

This equation has sales revenues taken from the business income statement, similar to operating costs and taxes. Investments in new operating capital show up as increases in fixed assets on the business’ balance sheet.

Free Cash Flow Formula 2:

Free Cash Flow = Net Operating Profit After Taxes (NOPAT) – Net Investment in Operating Capital

In this equation, NOPAT is the same as the first term used in the equation above (sales revenue – operating costs and taxes). Net investment in operating capital is the same as the third term; you can also use the increase in fixed assets on your business’ balance sheet.

Free Cash Flow Formula 3:

Free Cash Flow = Net Cash Flow From Operations – Capital Expenditures

In this equation, net cash flow from operations comes from the first section of the statement of cash flows. Capital expenditures come from the increase in fixed assets off the balance sheet.

What Can Free Cash Flow Tell You?

Free cash flow can tell you a lot about a business and how healthy it truly is. Businesses with minimal capital expenditures (long-term investments) typically have a steady FCF over time that will usually approximate net income. Businesses that have to make bigger long-term investments — such as buying equipment or additional buildings — will have a more volatile FCF.

For example, a business that relies on the brainpower of its employees as its major product cuts out the need for more capital expenditures. This type of business would typically produce a stable free cash flow over time, resulting in net income year-to-year. A business like this is very capital-light. For it to grow, it doesn’t have to continue to build and invest in additional office buildings or factories. Rather, it would hire more employees whose salaries are paid as services are produced and sold.

On the flip side of this, a business that has to make billion-dollar investments in machinery and equipment results in a more volatile free cash flow. In order to continue growing, those investments have to be made. For example, an oil and gas company needs to invest in specific equipment to get those fuels above the ground.

The maturity of a business will also affect its FCF. Mature businesses produce more consistent free cash flow because they aren’t continuously making large investments in order to grow. Younger companies produce minimal FCF because the cash they generate from operations is typically put back into the business.

Business Is Never Static

There are so many variables to the success of a business. Some can be controlled (e.g., product output), while others — such as the state of the economy — cannot. Whether your business is producing FCF or it has yet to generate any, understanding your financial health is key to your success. FCF is just one component of that.

If you notice that your business no longer generates FCF and is running out of cash in general, there are steps you can take to get your business back on its feet, such as negotiating with vendors and suppliers, restructuring invoices, selling inventory or possibly taking out a business loan. Once your cash flow is stable, take a look at your business and plan out how you can avoid cash flow problems in the future.

Which formula do you use to calculate free cash flow? Tweet us at @Revenued_com.

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