Whether you're an experienced business owner or just starting out in entrepreneurship, understanding free cash flow (FCF) is critical.
Free cash flow It forms the backbone of financial analysis, telling you more than just profits or losses. But what exactly is free cash flow, and why should it matter to you?
In this KPI glossary entry, we'll unravel free cash flow and learn why it's essential for driving your business forward.
Free cash flow indicates the amount of cash remaining after a company covers its capital expenditures (such as buying equipment or upgrading facilities).
In simpler terms, it's the money left over after paying for all the essential investments needed to maintain and grow your business.
Free cash flow is crucial because it provides a realistic picture of your financial health and profitability. Unlike net income, FCF offers a raw, unfiltered look at how much cash is genuinely available. This metric is particularly valuable for business owners who must reinvest in their operations, pay dividends, or reduce debt.
Investors often prefer companies with strong and stable free cash flow. This shows that a company can generate enough cash to sustain and grow its operations independently. It's a performance measure that cuts through the noise, focusing on a business's core operational success.
Moreover, companies use free cash flow as a key performance indicator to evaluate their financial strategies. Whether you're looking to expand your business, introduce new products, or simply keep your shareholders happy, free cash flow provides the clarity you need.
Cash flow forecasting can help your business to anticipate your business's future cash flow needs and plan accordingly.
If you'd like to learn more about cash flow forecasting, you can read more about this in our comprehensive guide: what is a cash flow forecast?
You can also read our blog, understanding cash flow analysis, for strategies to improve your cash flow management.
Calculating free cash flow might seem daunting initially, but it's a straightforward process once you get the hang of it. Start by understanding the simple formula: Free Cash Flow = Operating Cash Flow - Capital Expenditures.
Operating cash flow, often seen in a company's cash flow statement, illustrates the cash generated from core business activities. This figure excludes investments and financing activities, focusing solely on operational efficiency. For instance, it accounts for revenue collected from sales and deducts operating expenses like salaries and rent.
Next, you subtract capital expenditures. These are funds spent on physical assets such as property, plant, and equipment. Capital expenditures are crucial for business growth, but they also represent cash outflows that impact your free cash flow.
For a seamless calculation, ensure your financial statements are up to date and detailed. Inaccurate or incomplete records can lead to misleading results, which could negatively affect your financial decisions. Regularly tracking free cash flow helps you stay on top of your cash management and make informed choices about expansions or cost-cutting measures.
Suppose you're a small business owner. Accurately calculating free cash flow can reveal whether you have sufficient funds to reinvest in new technology, hire additional staff, or reduce existing debt. Having this insight can be a game-changer, enabling you to craft strategies with confidence.
To place this into perspective, let’s consider a real-world example by looking at Apple’s financials.
In 2020, Apple’s operating cash flow was $80.67 billion, while its capital expenditures stood at $7.3 billion. The free cash flow calculation would be:
FCF = $80.67 billion- $7.3 billion = $73.37 billion
This high free cash flow figure indicates Apple’s robust financial health, providing ample cash for dividends, stock buybacks, and innovation.
Free cash flow is not one-size-fits-all. Different types cater to various analytical needs, providing a nuanced view of financial health.
Let's dive into the main types of FCF.
1. Levered free cash flow: This type focuses on cash flow after interest payments on debt. It's the money available after the company has met its financial obligations. This metric helps business owners understand how much cash is left after debt servicing, which is vital for companies with significant borrowings.
2. Unlevered free cash flow: Unlike its levered counterpart, unlevered free cash flow ignores interest payments. It presents a clearer view of a company's operational performance without factoring in financing activities. Investors favour this metric as it highlights the cash generated purely from operations.
3. Free cash flow to equity (FCFE): FCFE drills down to the cash available to shareholders after covering all operational expenses and debts. It's a vital metric for companies with equity investors, showing how much cash can be distributed as dividends or reinvested to generate shareholder value.
4. Free cash flow to the firm (FCFF): This measure looks at cash available to all capital providers, including both equity and debt holders. FCFF is often used in valuation models to assess the overall financial health of a business, considering its obligations to all stakeholders.
Each of these free cash flow types serves different analytical purposes, catering to the diverse needs of business owners and investors. Levered and unlevered FCFs offer insights into debt management and operational efficiency, while FCFE and FCFF provide a broader view of a company's ability to generate value for shareholders.
One crucial skill for any business owner is navigating through financial statements to extract meaningful data.
When it comes to free cash flow, key documents include the cash flow statement, income statement, and balance sheet.
This statement highlights how much cash enters and exits your business. Look closely at the operating activities section for operating cash flow and the investing activities section for capital expenditures.
Your income statement, or profit and loss statement, outlines your revenues and expenses. While it doesn't directly show cash flow, it provides insights into profit margins and operating expenses that influence free cash flow.
Your balance sheet details your assets, liabilities, and equity. Elements like current assets and current liabilities can indirectly impact your free cash flow by influencing net working capital.
A holistic view requires connecting data from these statements. For instance, a significant asset purchase mentioned in the balance sheet will reflect in capital expenditures on the cash flow statement. Understanding these connections can offer a comprehensive view of your financial health and help you better interpret free cash flow figures.
Like other formulas for finance, free cash flow has its pros and cons. On the upside, it gives you a clear picture of your company's financial flexibility. Strong free cash flow means you have the resources to pursue growth opportunities without relying on external financing, which can be costly or come with strings attached.
From an investor's viewpoint, high free cash flow indicates a healthy, profitable company. It often leads to increased dividends and share buybacks, ultimately boosting shareholder value. This metric focuses on the real cash generated by your business.
However, free cash flow can sometimes be volatile, especially in industries subject to seasonal fluctuations or one-time events. For example, a significant CapEx in a particular quarter can skew your free cash flow, making it look worse than it is. Therefore, it's crucial to look at FCF trends over several periods to get a more accurate picture.
Another downside is the potential for underinvestment. Focusing too much on free cash flow might lead to cutting back on essential capital expenditures, which could hurt long-term growth. Business owners need to strike a balance, ensuring that they don't sacrifice future profitability for short-term gains.
Free cash flow is often confused with operating cash flow. However, both serve different purposes in financial analysis.
Operating cash flow (OCF) measures the cash generated from your core business activities, giving an insight into how well your operations perform.
Free cash flow, on the other hand, accounts for capital expenditures like equipment and infrastructure investments. Subtracting capital expenses from OCF provides a broader view of financial health and gives investors an idea of potential returns after reinvesting in the business. FCF is one of Fathom's default KPIs.
Both OCF and FCF play complementary roles. Understanding the distinction helps in a comprehensive business evaluation. While OCF focuses on your immediate operational health, FCF looks at long-term sustainability and growth opportunities.
As a small business owner, knowing both these metrics enables you to make more informed strategic decisions, balancing day-to-day operations with future investments.
Understanding and calculating free cash flow isn’t just an academic exercise. It’s a business-critical activity that provides valuable insights into your company's operational efficiency and financial health. Regular monitoring helps you identify potential issues early, enabling you to make informed, strategic decisions.
By monitoring free cash flow closely, you can gauge how well your business is performing and plan for sustainable growth. Whether it's through expansions, cutting unnecessary costs, or simply ensuring that you have the cash reserves to weather economic downturns, free cash flow should be a key component of your financial strategy.
Did you know Fathom automatically calculates a comprehensive range of financial KPIs, including your free cash flow? For more information, check out our list of default KPIs or visit our help centre.
Additionally, explore our tutorial webinars and testimonials on the Fathom blog.
KPI tracking software can be used by businesses looking to gain a clearer understanding of their performance by tracking Key Performance Indicators (KPIs) and metrics that matter to them.
For more information on defining and tracking the KPIs that are most important to your company, watch our KPIs Demystified webinar.
We have also written glossary entries on other default Fathom KPI’s that you may want to explore, such as cash flow margin, cash flow coverage ratio, and cash flow adequacy ratio.
Smarter growth starts with the right metrics. With Fathom, you can select from 50+ common financial KPIs or create your KPIs for a comprehensive view of business health and performance. If you're not yet a Fathom user, remember you can explore the capabilities of our KPI tracking software when you start a free 14-day trial today.
A good free cash flow is when a company's cash inflows exceed its cash outflows, allowing it to have excess cash to invest back into the business, pay off debt, or distribute to shareholders.
To calculate free cash flow, subtract capital expenditures from operating cash flow.
The formula is FCF = Operating Cash Flow - Capital Expenditures.
As defined by Investopedia, free cash flow conversion is a liquidity ratio that measures your ability to convert operating profits into free cash flow throughout a given period.
The FCF conversion rate helps your business to evaluate the quality of its cash flow generation.
Free cash flow margin is defined as a liquidity ratio that measures your business's efficiency in converting revenue into free cash flow.
Net cash flow refers to the total cash flowing into and out of a business, including both operating and non-operating activities. Free cash flow, on the other hand, focuses on the cash generated by the business's core operations after accounting for capital expenditures.
No, free cash flow is not the same as profit. Profit is a company's total revenue minus its total expenses, whereas free cash flow is the cash a company has left over after covering its operating and capital expenses. Profit does not consider capital expenditures, which are deducted to calculate free cash flow.
Kit is the Content Marketing Manager for The Access Group APAC and Fathom. He is a former journalist with extensive experience in content writing and copywriting across various industries, including higher education, not-for-profit, and finance sectors.
