How to Understand Your Business’s Health
and Profitability through Free Cash Flow

Financial management is one of the most important skills for running a successful and sustainable business. When it comes to understanding the health of your business and how you’re going to plan and pay for expansion, one of the most useful indicators is your “Free Cash Flow.” Used properly, free cash flow gives you and others useful insight into how efficient and profitable your business is.

You can use this information to make better business decisions, encourage suppliers and customers to work with you or even obtain financing for your future business plans. Before learning about how to calculate and use free cash flow, we recommend reading our guides to cash flow statements and forecasting your cash flow.

What Is Free Cash Flow?

Free cash flow is an excellent way to understand your business’ profitability, health and sustainability. Simply put, it is the amount of money you have left after you have paid for all your costs (including capital expenditures and operating expenses).

Your free cash flow is essentially the money you have that you could take out as profit, use to pay down debt, return to investors or reinvest to grow the business. Your free cash flow varies on a day-to-day basis. Although you may not calculate it daily, regularly reviewing free cash flow can give you powerful insight into how your business is doing and help you make smarter decisions.

Calculating Free Cash Flow

There are several different ways to calculate free cash flow and it doesn’t matter which one you use as long as you’re consistent. In this guide, we’ll cover a simplified calculation — you can always speak to your accountant if you want to use an alternative method.

Your free cash flow is:

Revenues Collected from Sales
  • Costs of supplying goods or services
  • Other operating expenses
  • Costs of capital expenditure / fixed assets
  • Taxes due on profits

= Free Cash Flow

An Example of Free Cash Flow

It’s the end of the year and your business, Blue Widget Co. wants to show free cash flow to attract investors and secure a bank loan. Here’s how you would work it out:

Revenues Received in the Last Year

$1,500,000

Cost of buying raw materials and producing widgets

— $600,000

Other operating expenses

— $300,000

Cost of capital expenditure

— $150,000

Taxes due

— $180,000

Free Cash Flow

= $270,000

Understanding Revenues, Expenses and Taxes

Let’s break down the figures you use to calculate each part of free cash flow.

Revenues Received

This is the money you get for selling goods and services. You can get this from your income statement.

Costs of Supplying Goods or Services

This is the actual cost of producing what you sell. For products this would be the raw material, manufacturing and associated costs. For services, it might include the salaries of the people providing the services and the incidental costs they incur.

Other Operating Expenses

These are all the other expenses your business incurs like employee salaries not calculated above, logistics, shipping, distribution, utility bills, rentals, sales, marketing, websites, insurance, exchange rate and bank fees, payment processing, etc. It’s important to understand all your operational costs and not “double count” them with the cost of supplying goods and services.

Costs of Capital Expenditures

Capital expenditures refer to money spent that increases the overall assets of your business. This might mean purchasing new premises, buying vehicles, investing in equipment or other big-ticket spending. Typically, any capital expenditures will be recorded as “business assets” on your balance sheet.

Taxes Due

There are various taxes you will need to pay in your business. These might include:

  • Payroll and employment tax
  • Self-employment tax
  • Sales and use tax
  • Corporation tax
  • State tax
  • Other tax

What Can You Use Free Cash Flow For?

Cash realized as part of your free cash flow can be used for various purposes, including:

  • Building up a cash buffer in your business: Having cash on hand can insulate you from financial shocks and surprises, reduce the risk of going overdrawn and give you peace of mind.
  • Paying down your debts: If your business has debt, you can use free cash flow to reduce what you owe. This will lessen the interest you need to pay, enhancing your future free cash flow even more.
  • Expanding the business: You can use free cash to develop new products and services, pay for marketing and promotion, expand into new markets, buy new equipment or assets and otherwise grow the business.
  • Return money to investors: If you have investors in your business, you can return some of your free cash to them as disbursements, dividends or repayments.
  • Show business and financial strength: If you’re trying to encourage new investment or want to build partnerships with others, a healthy free cash flow is a great way to show business success.
  • Take money out as profit: Finally, you could choose to take money out of the business yourself as profit, give your employees a bonus or otherwise spend the money as you see fit.

Comparing Free Cash Flow to Forecast Cash Flow

It can be useful to compare your actual free cash flow to your previous cash flow forecasts. This will help you tweak and refine your forecasting models so you can better understand future profitability.

 

Using Free Cash Flow for Budgeting

Remember to figure your free cash flow into future business budgeting. As your business expands, costs and revenues are likely to increase, so aligning your budget with free cash flow will be vital to sustained and healthy growth.

Remember that your free cash flow will change over time. We recommend reviewing your free cash flow on a regular basis to understand how your business is doing. You can then make strong, informed decisions on business strategy, so you can use that free cash in the most effective way.

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