What is Free Cash Flow and Why Is It Important?
July 27, 2021 |
The C2FO Team
Though not shown on your financials, free cash flow is arguably one of your company’s most important metrics. Here’s how to find, understand and use it.
Free cash flow, or “FCF,” is a term often mentioned, but not readily understood. That’s probably because it’s not a direct lift from your company’s financial statements. Instead, FCF is calculated from those statements’ numbers.
A similar yet more familiar metric is days sales outstanding (DSO), which tells you how long outstanding balances are carried in your receivables, but doesn’t appear on an income statement or balance sheet. You can figure DSO by dividing accounts receivable by total credit sales during a set period of time, then multiplying it by that number of days. Generally, a DSO higher than 30 can signal a need to borrow or even tighten your credit or sales policies to meet upcoming obligations. It can also help you forecast cash flow. Although AR appears on your financials’ balance sheet, calculating DSO can explain its usefulness.
Calculating FCF can also be valuable in understanding your company’s financial health. As they say on the show Shark Tank, “Know your numbers!” Understanding FCF gives you a stronger grasp of your cash position and how much money you have on hand to invest in growing your business.
What is free cash flow?
Put simply, free cash flow is what remains after subtracting capital expenditures (often referred to as “CAPEX”) from operating cash flow. This metric quickly indicates your company’s ability to meet upcoming expenses.
Generally speaking, the more free cash flow you have, the more options you have to invest in and expand your business. Again, FCF won’t jump out from your financials, but it can be easily determined.
How is free cash flow calculated?
Only two steps are needed to calculate FCF:
- Locate Operating Cash Flow from a Statement of Cash Flows, which indicates cash flow changes over the financial period.
- Find the CAPEX number (typically labelled plant and equipment), also on the Statement of Cash Flows, and subtract it from Operating Cash Flow to reveal FCF.
An example of this is shown in the 2020 results of Warren Buffet’s Berkshire Hathaway, where $26,761,000 of year-end FCF resulted from subtracting $13,012,000 of CAPEX from $39,773,000 of operating cash flow. Companies of all sizes can calculate FCF, though it applies more to manufacturing and distribution companies — with their routine capital expenditures — than to providers of financial or similar services.
In that example, the formula for calculating FCF is fairly simple:
A slightly different model calculates FCF by adding net income to non-cash expenses (depreciation and amortisation) and then subtracting the change in working capital and CAPEX. For this more complicated formula, you’ll need to use your income statement and balance sheet, and calculate working capital by subtracting liabilities from assets.
Why is free cash flow important?
Free cash flow is a basic, though unstated, measure of your business’s health and near-term viability. Think of it as the “free and clear” income after satisfying all internal and external obligations. While net income is how much money a business makes, free cash flow is how much an owner can take from the business. Consider it as “the money in the owner’s pocket” at any given time.
Business leaders and owners place a high value on FCF. As Amazon CEO Jeff Bezos told Bloomberg in 2013, “It’s the absolute dollar free cash flow per share that you want to maximise.” Since Bezos made that statement, Amazon shares have risen 1200% (and 75% since January 2020), reflecting the retail giant’s ability to generate and maintain a significant amount of free cash flow.
For much smaller businesses, FCF is important because it tells them how much money is available to spend as they please, whether that’s adding headcount, buying new equipment, launching a new product or awarding employees.
How can you put free cash flow to use?
Having more FCF on hand provides more opportunities for you and your business.
Here are just a few ways to put that cash to work:
- Take a distribution as a reward for their risk or results.
- Invest in an alternate business, preferably one with a healthy amount of free cash flow itself.
- Reinvest in the primary business. You can spend to develop an alternate product line or, more commonly, buy back discounted ownership shares. Or you could also invest in expediting slow AR collections, freeing up working capital to grow revenue, reduce debt or add to inventory, for example.
Who needs to know about your free cash flow?
Though revenue growth and profitability frequently capture the headlines, it’s often the less commonly known financial measures like free cash flow that best tell a business’s current value.
Small business owners and their investors will have a keen interest in knowing the firm’s free cash flow. Since the metric also easily answers the “What’s in it for me?” question, lenders, prospective buyers and business brokers will also have a strong desire to know.
By having a ready answer to the “What’s your free cash flow?” question, you’ll instil confidence in others and prove that you i