No business can thrive and grow over the long term without generating cash flow. It’s a common metric that internal teams and external stakeholders are interested in, helping to drive investment decisions, operational strategy, procurement activities, and more.
Free cash flow is one way companies can analyze their cash flows, which helps to show how effectively they are using the cash generated by core operations.
Below, we’ll cover free cash flow in further detail, review how to calculate it, and provide helpful tips on how to better manage it.
What is free cash flow?
Definition of free cash flow
Free cash flow (FCF) is a metric used to demonstrate the financial health of a company. It represents the cash that’s left over after covering operating expenses and capital expenditures.
FCF is used by both internal decision-makers and investors to determine how much discretionary cash the company has to spend on growth initiatives, debt repayment, dividends, and other uses that increase value.
Importantly, free cash flow is not the same thing as net cash flow. While similar, there are some discrepancies between the two values, so they’re not perfectly interchangeable.
Net cash flow is the net value of the cash the company used or produced during a given period. It considers all the sources and uses of cash across operating, investing, and financing activities.
On the other hand, free cash flow is focused on the cash generated from operating activities only, plus what was spent on capital expenditures.
Free cash flow vs. net income
Free cash flow does provide a measure of a company’s profitability. However, it has some key differences between another common profit metric — net income.
As a reminder, net income is the bottom line on the income statement. It represents the company’s total profit after accounting for all expenses, interest payments, and taxes.
Thus, the free cash flow measure omits certain costs and expenses that are figured into the net income calculation, like taxes. This includes non-cash expenses, like depreciation, that don’t result in a change to the cash balance, which the FCF formula adjusts for.
Free cash flow vs. EBITDA
EBITDA is another profitability metric that stakeholders use to assess a company. EBITDA stands for earnings before interest, taxes, depreciation, and amortization. Thus, it’s calculated by adding back each of these line items to the company’s reported net income.
FCF is similar to EBITDA in that they both exclude non-cash expenses like depreciation, amortization, and taxes incurred. They help provide a measure of the company’s earnings from core operations.
However, EBITDA represents the company’s profits on an accrual basis, while FCF provides a more accurate measure of the cash the business has actually exchanged, not just expenses they’ve incurred.
How to calculate free cash flow
Free cash flow formula
The simplest formula to calculate free cash flow is:
Each of these values should be readily available on the cash flow statement, including the net cash produced (or used) by operating activities, and the cash outflow for capital expenditures from the investing activities section. The difference between these figures is the free cash flow.
Step-by-step guide to calculate free cash flow
With the prepared cash flow statement, finding the company’s free cash flow can be done in just a few simple steps.
Step 1: Find the operating cash flow
First, find the operating cash flow from the cash flow statement. This can either be a negative or positive value, representing the cash the business either used or generated from operating activities.
It considers all the cash the company has collected during the period for the sale of goods and services. Plus, it accounts for the cash outflows the business made to support operations, like paying suppliers.
Step 2: Determine the capital expenditures
The next step is to identify the amount the company spent on capital expenditures. This figure is typically included in the investing activities section of the cash flow statement.
It shows what the company spent to acquire, upgrade, or maintain its fixed assets, like property, equipment, or machinery.
If the company bought a new vehicle, purchased new office furniture, or renovated its retail space, the cash spent on these transactions is considered CapEx.
Step 3: Calculate the free cash flow
Find the free cash flow for the business by subtracting capital expenditures from the net cash flows from operating activities.
Free cash flow example
Let’s find the free cash flow for XYZ Inc., which prepared the following cash flow statement for the previous year:
Using the highlighted figures, we can calculate the free cash flow with the following steps:
Interpreting Free Cash Flow
In general, companies aim to generate a positive free cash flow value, indicating that they have some cash left over after taking care of their bills and maintaining the equipment that supports operations.
The free cash flow they generate can be used on initiatives to increase their value, whether that’s reinvesting in the business, paying down debts, or making dividend payments to investors. For this reason, FCF is a common metric investors use to perform a company valuation, showing that a company can meet its financial obligations while still having some left over.
The emphasis here is on the “free” part of FCF. It represents only the incoming cash flows the company generates through operating activities, so it doesn’t capture any funds the business receives from creditors, loans, or investors that will need to be paid back.
Positive free cash flow alone doesn’t automatically mean a company is financially healthy and stable. However, consistently positive FCF combined with other profitability metrics can help drive informed decision making for investors and internal teams.
Benefits of free cash flow
As mentioned throughout, FCF provides important insights to both internal teams and external stakeholders about the business’s ability to cover operating costs and have cash left over for value-add activities. Here are some of the key benefits of free cash flow analysis:
Supports informed decision-making internally
In-house teams might evaluate free cash flow to determine how much cash is available to reinvest in the business, repay creditors, and distribute dividends to investors. In this way, it helps inform strategic decisions and prevent the business overextending itself.
They might also be interested in monitoring how free cash flow has fluctuated over the years, showing how well they’re controlling working capital and optimizing operating expenses.
Helps to evaluate investment opportunities
FCF is a common metric investors use to perform a company valuation and support investment decisions.
To reiterate, a company that generates positive free cash flow will be better able to reinvest in projects that increase its value, supporting a positive return for investors. Plus, it means they may be able to redistribute excess funds to investors through dividend payments.
In contrast, a company with a negative FCF may not be able to sustain its operations, and doesn’t have any cash left over to meet debt obligations, nonetheless share the wealth with investors.
Limitations of free cash flow
Free cash flow is not a foolproof metric for determining a company’s financial health. There are some potential limitations, including:
Industry variations
FCF may not be comparable between companies in different industries. Certain sectors are more capital-intensive than others, like construction or retail, compared to companies in the finance or technology space.
Thus, what’s considered a “good” FCF is not universal, and it’s typically only useful to compare a company against its past performance or competitors in the same industry.
Drops during growth periods
Finally, the FCF may drop when a company is going through a growth period. If they’re investing in fixed assets that will support further expansion of the business, it will detract from the FCF temporarily with greater CapEx spending.
Thus, the FCF value alone may not tell the full picture about the company’s performance and growth prospects. It doesn’t distinguish between recurring or one-off cash outflows, which can be misleading.
Improving free cash flow
Business leaders are often focused on improving free cash flow, not only to enhance their appeal to investors, but also to have more cash available for growth and reinvestment. The following strategies are some of the ways for companies to approach this:
Minimize operating expenses
Companies may be able to improve FCF by better controlling operating expenses. This figure directly impacts the net income figure, which is the starting point for the operating cash flow calculation using the direct method.
Reducing or eliminating certain operating expenses, like negotiating rent payments or cutting back spending on travel or office supplies, can result in a higher net income, which has a positive impact on the FCF.
Focus on sales growth
The other side of the net income equation is top-line revenues. Thus, businesses can also increase FCF by improving sales performance.
Depending on the sales growth strategy, it will likely cost the business more to acquire new customers. If improving FCF is the goal, it may be beneficial to employ upselling or cross-selling strategies, retargeting campaigns, and other types of promotional efforts to earn more sales from the customers they’ve already acquired.
Optimize working capital
Alternatively, companies can improve FCF by optimizing working capital, like better controlling inventory, receivables, and payables. This means a quicker collection of the cash they’re owed, turning more unsold inventory into sales, and securing favorable terms on short-term obligations.
For example, if the business has a large amount of cash held up in unsold inventory, it can weigh on operating cash flows, with a negative impact on free cash flow.
It may be easier said than done, but teams should assess aging inventory and engage in promotional or discounting activities to help move units. Even if they have to sell the units at a discount, it’s better than continuing to leave them on the shelves, generating no cash.
Use the right tools
Maintaining financial records manually and calculating free cash flow by hand can make the process much more difficult and cumbersome.
In the digital age, there are helpful tools companies can use to streamline financial management and more easily track the key metrics that help them analyze and manage operations, like BILL’s integrated financial management platform.
Tools like BILL compile key financial data in one place for easy accessibility, offer intuitive data visualizations to quickly gauge performance, and automate certain tasks to improve efficiency and productivity.
Understand your cash flows with BILL
Calculating FCF provides a snapshot of your company’s financial health at a certain point in time. While it’s useful for planning and budgeting, it doesn’t provide a future-looking estimate of where your cash flows are heading.
With BILL’s cash flow forecasting tool, you’ll be able to predict future cash flows for more precise and informed decision-making.
By syncing with your accounting software, BILL will provide you with dashboards to monitor key cash metrics in real time, quickly generate cash flow projections up to 13 months ahead, and predict the impact of different business decisions on your cash flows.
Start your trial of BILL’s cash flow forecasting tool today.
