Free Cash Flow: What it is and how to calculate it
Introduction- Free Cash Flow
When you are running a business, it will be crucial for you to know how much cash your business is generating after providing for all the necessary expenses, including payroll, inventory, taxes and rent. This can be done by free cash flow calculation. It lets business owners know how much capital they have left to use at their discretion after providing for all the necessary expenses.
Free cash flow can be termed an indicator of the financial health of a company. Free cash flow analysis helps a business make key decisions, like whether to invest in business expansion or cut down on expenses. Investors use free cash flow calculations to estimate how much money will be left with the company that can be distributed as dividend payments or used for share buybacks.
How to Calculate Free Cash Flow?
There are multiple methods of free cash flow calculation depending on the financial information available. The simplest method to calculate free cash flow is subtracting the capital expenditures of a business from its total operating cash flow.
In case a company does not list the operating cash flow and capital expenditures, there are a few other free cash flow formulae that can be used, such as –
Free Cash Flow = Sales Revenue - (Operating costs + Taxes) - Required Investments in Operating Capital
Free Cash Flow = Net Operating Profit After Taxes - Net Investment in Operating Capital
Importance and Limitations of Free Cash Flow
A positive free cash flow indicates good business health. Businesses with healthy free cash flow tend to have enough cash in hand to clear their dues every month and still have some capital left on their balance sheet. A company with a consistently high or rising free cash flow is usually doing well and has the option to expand. Whereas a business with consistently low or declining free cash flow may not have reserve capital and could also struggle to meet all its expenses. Seasoned investors tend to look for companies with consistently rising free cash flow.
On the other hand, it is important to note that low free cash flow does not necessarily mean a business is in poor shape. There are instances where even a healthy company can see a sharp dip in its free cash flow while, at the same time, its business could flourish.
Usually, older and more established companies tend to have a consistent free cash flow. In contrast, new businesses typically invest more in their growth. It is recommended to look at the free cash flows in conjunction with other financial metrics to arrive at a conclusion. Another important factor determining the free cash flow of a company is the industry in which the company is working. Not all industries require companies to spend large sums of money on inventory, land, or equipment. Free cash flow is a good indicator of the financial health of a business when used for evaluating a non-financial enterprise, like service or manufacturing firms, and not banks or investment firms.
While free cash flow calculation is more reliable than many other financial calculations, it is not completely immune to manipulation. There is room for accounting trickery. For instance, accounts payable and accounts receivable can be manipulated to boost the free cash flow.
Benefits of Free Cash Flow
Since Free Cash Flow accounts for the changes or alterations in working capital, it can offer vital information about the financial health of the business that may not be revealed by just examining the balance sheet. For example, consider a company that has been making Rs 40 crore a year in its net income for the last 10 years. Now, this may seem quite stable.
However, what if its FCF has constantly been dropping over the last two years since the inventories were piling up (resulting in cash outflow), vendors were demanding faster payments (cash outflow) while customers were delaying payments (reduced cash inflow)? In such a case, free cash flow analysis would reveal a major financial weakness that wouldn’t come to light just by examining the income statement alone. Other than this, free cash flow is used by shareholders to analyse the viability of future dividend payments that they can expect.
Free Cash Flow is one of the key metrics of a business. However, investors often tend to focus more on other metrics like revenues and the growth of the business. While these metrics are essential, how much cash a business generates once it meets all its operating expenses and what is it doing with it is equally important for the future prospects of the business as well as for returning value to shareholders.
1. What are the factors affecting Free Cash Flow?
Some of the factors affecting the free cash flow of a business include sales, capital expenditure, interest payments, taxes, changes in the net working capital, and inflation.
2. What are the 5 main uses of free cash flow?
The 5 main uses of free cash flow are
● Paying dividends
● Share repurchases
● Repaying debt
● Reinvesting in the company’s growth
3. Is free cash flow the same as profit?
The main difference between profit and free cash flow is that while profit refers to the amount left on the profit and loss statement after all the expenses have been cleared, free cash flow refers to the actual flow of cash in or out of business.