When it comes to business finance, there are a lot of different metrics to consider. While some might be easier to calculate than others, knowing how to evaluate the financial health of your business and profitability is crucial.
With formulas like Free Cash Flow (FCF), you can better understand where your business stands and what your operational capacity is. This article will walk you through the basics of free cash flow, including what it is, how to calculate it, and what the limitations are.
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At its core, free cash flow is one of the measures used to understand profitability and it is a type of formula that can be used to calculate profits.
It helps you understand how much money your business has left after paying for all the operational costs needed to run. This can include payroll, building costs, taxes, maintenance and products or inventory. The amount left over is considered free cash flow. It can be used to ensure the business receives the support it needs to be profitable and successful.
As you’ve probably started to see, free cash flow is a crucial measure for your business and its investors. It helps you understand how successful the business is at generating cash and strategize on how to increase cash flow.
Free cash flow is also a helpful metric because it gives businesses an understanding of where to focus resources to grow the business further. It can serve as a buffer as generated cash can be used strategically to grow the business.
If you’re thinking about securing funds for your company, free cash flow is a particularly important metric for investors because it’s one of the hardest numbers to manipulate. It also helps them understand how much money your business has available to reinvest back into the business to increase shareholder value including:
- Repaying creditors for any outstanding loans or debts
- Distributing dividend payments
- Issuing share buybacks
- Expanding your business to make more money
If you’re a small business thinking about international expansion and entering new countries, having positive free cash flow is key to be able to do that. Growth is an exciting prospect but you need to be mindful of when the right time to expand into new markets should be. It's best to have a significant amount of money saved up front - especially considering that revenue will take time - because you'll most probably spend a larger amount on:
- The type of legal entity you choose to set up
- Office premises and equipment
- Hiring new employees or repatriating employees from one location to another
Another reason why free cash flow is so important is that it can save a business if need be. Businesses can use the funds for cash reserves for emergencies and slow periods.
While FCF is an indicator of profitability and the health of your business, it’s important to remember that it shouldn’t be looked at on its own. Also worth noting that sometimes your business might be in negative cash flow for various reasons, the article will explore shortly.
So now that you know why free cash flow is an important metric, it’s calculation time. There are quite a few variations of the formula out there that you can use.
But the most common formula to use when calculating free cash flow is:
|Operating cash flow - Capital expenditures = Free cash flow¹|
There are multiple ways to do so when it comes to calculating free cash flow because financial statements are not the same for each company. The calculations largely depend on what your business deems as operational and capital expenses.
If you don’t have a cash flow statement, you can use income sheets and balances for calculations. However, even with the basic free cash flow calculation, it’s always worth pairing it with multiple types of calculation for better accuracy and to gain a deeper insight into how the business is performing.
To calculate FCF from your cash flow statement, you’ll need to identify your operating cash flow and capital expenditure.
Operating cash flow refers to any money generated through the normal operation of the business, minus any taxes paid.
Capital expenditures refer to income spent on business expenses related to equipment and property necessary for the business to operate (i.e., computers and tech equipment, office rent, refurbishment or renovations, etc.)
For companies with multiple locations -including international-, capital expenditures can refer to expenses incurred for future growth and to maintain present operating levels - anything that will be used for more than a year. That can include new offices, equipment, renovations and any other investments you make in the business.
Once you’ve identified the numbers from your cash flow statement, your formula will be:
|Operating cash flow - Capital expenditures = Free cash flow|
Another approach for calculating FCF is to look at Earnings Before Interest and Tax (EBIT). For this, you’ll have to identify the total cash your business has generated before accounting for earnings and taxes and subtracting the earnings from investments made into the business.
However, a more important metric is Earnings Before Interest, Tax, Depreciation, and Amortization (EBITDA)², which provides a more accurate picture. While the two metrics look the same on the face of it, the difference is that EBITDA considers your earnings before taxes, interest payments, and whether the value of your assets has decreased over time - the latter can be found on cash flow statements.
If you’re using EBIT or EBITDA to calculate FCF, your formula will be:
|EBIT(DA) + income generated - capital expenditure - increases in working capital (i.e., higher rents, more equipment) = FCF.³|
Alternatively, you can use a shorter and easier formula for free cash flow:
|Net operating profit after taxes - net investment in operating capital = FCF.|
Lastly, another method for calculating FCF is to look at sales revenue, the income your business receives from selling goods and/or providing services.
Sales revenue could include both domestic and international sales. If your business sells products or services in other regions such as Europe and Asia, any e-commerce revenue and brick and mortar sales, all of that activity will go under sales revenue.
Once that’s identified, you’ll need to identify how much revenue is needed to keep the business running and current operational costs. Think about the actual cost of sales and what investments are needed to run your business operations as it is now. That could include supplier costs, warehouse fees, sales offices, and other expenses incurred. Finding ways to reduce capital expenses for international products can help drive positive cash flow.
In this case, the formula would look like:
|sales revenue - (operating costs such as day-to-day expenses + taxes) - required investments in operating capital = FCF|
While yes, FCF is a crucial metric, there are some limitations. It shouldn’t be used in isolation when you’re looking at the financial performance of your business but in conjunction with other metrics to give you a better idea of financial performance.
FCF by itself won’t give you the precise information needed and might not always paint the right picture.
- For example, low FCF numbers don’t necessarily mean the business isn’t doing well. Cash flow could be low due to reinvestments in capital or debt repayments to help the business stabilize long-term.
- Comparatively, a high FCF could mean that the company isn’t reinvesting in itself and isn’t thinking about how to drive further growth and better profits.
One of the more accurate ways to measure FCF is over multiple periods of time, so you have a benchmark for comparison. And with each calculation, try not to jump to conclusions. Measuring more frequently, such as on a monthly or even quarterly basis, will give you a much deeper understanding of cash flow to base decisions on.
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As we’ve seen in the different variations, FCF is very much influenced by operational costs. When paying suppliers and/or employees abroad, fees incurred do matter and can play a big role in inflating operational costs.
However, using services such as Wise can help with that. You can send and receive money with Wise the cheap way. Save up to 19x compared to PayPal. The fees are simple, transparent, and upfront, so you’ll know what you’ll pay for your transfer, every time - no guesswork needed.
Wise also offers easy financial management services, allowing you to pay invoices, employees and manage subscriptions fast, in one click. See balances in different currencies, pay suppliers quickly, and take greater control over income - all in one place.
- Corporate finance institute - Free Cash Flow (FCF) Formula
- Corporate finance institute - EBITDA
- |ADAMS, Mollie T.; BHANDARI, Shyam B.; On the definition, measurement, and use of the free cash flow concept in financial reporting and analysis: A review and recommendations; 2017. Journal of Accounting and Finance Vol. 17(1) 2017
All sources checked 20 September 2021
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