Explaining Free Cash Flow and Its Importance

Businesses measure their performance using sales numbers and quarterly earnings. However, shareholders and owners look beyond these reports to estimate their profit shares, room for investments and retaining capital.

The free cash flow is the metric for this information. It reflects the money remaining after paying all business dues, which is then distributed to stakeholders, new projects, and equity. Let’s discuss the FCF in more detail and explain how to calculate it.

The Free Cash Flow Explained

The amount of money left after paying fixed and variable costs, including operational expenses, overheads, raw materials and rents, is referred to as the free cash flow (FCF). This capital is used to distribute dividends and finance new business expansions. Alternatively, a company may choose to use this money to pay off its loans and reduce liabilities.

Entrepreneurs look at these financial figures before investing in a company or startup to understand how much they will gain and how much their return on investment is.

Common financial reports like balance sheets and profit and loss statements do not reflect this figure. Therefore, keeping this ratio in a positive range attracts investors and new shareholders.

FCF Components

The free cash flow is constructed from three main elements: the operating cash flow, the capital expenditure and working capital change. Let’s explain the relationship between these factors.

Operating Cash Flow

This represents the revenue generated from core business activities, whether selling a product, offering a service or manufacturing goods. The OCF demonstrates the inflows and outflows through sales, marketing, procurement and other income-generating operations.

For instance, if a business makes $100,000 in annual revenue but pays $75,000 in salaries and leases, its operating cash flow is $25,000.

Capital Expenditures

This indicates the capital invested to buy new fixtures and equipment, including lands, buildings and other real estate, to contribute to the company’s activity.

Production factories and manufacturing firms usually have high CapEx because they invest heavily in machinery, storage units, plants and equipment, resulting in less money available. However, their long-term goals and targets compensate for these expenses.

Working Capital Changes

The difference between current assets and current liabilities is called working capital, and changes in this margin affect the cash-flow statement.

The current assets include readily available capital, accounts receivable, and inventory, all of which can be converted into liquid assets. However, current liabilities include accounts payable, short-term loans and taxes.

Companies undertake various activities to reduce their liabilities, like debt payoff or financial restructuring for tax benefits. On the other hand, asset reduction includes selling equipment or buildings to decrease account and credit payables.

Calculation Method

There are two ways to calculate the free cash flow, depending on the available inputs. 

Method 1) Operating Cash Flow - Capital Expenditure

Method 2) Net Income + Non-Cash Cost - Working Capital Changes - Capital Expenditure

Calculation Example

Assume that a company reported the following figures. $100 million in net income, $10 million in non-cash expenses, $5 million in working capital changes, and $15 million in capital expenditure.

Measuring the free-flowing cash can be done in the following way:

FCF = Net Income + Non-Cash Cost - Working Capital Changes - Capital Expenditure

FCF = 100 + 10 - 5 - 15 = 90 ⇒ $90 million in Free Cash Flow

Interpretation

This means the company has $90 million available for dividend distribution, issuing stock pay-back programs, paying off loans, expand to new business lines. This capital was retained after deducting wages, raw materials cost, lease, payable taxes, and other expenses.

Final Remarks

The free cash flow is a financial indicator of a business’s economic well-being and shareholder’s profitability. It represents the money left for stockholders after paying all taxes, interests, wages and rents.