How to calculate free cash flow: Learn the methods, limitations, and why it’s important
Every small business needs to know exactly how much cash it has in the bank after accounting for all expenses and costs. That’s why it’s so important to manage the cash flow of a small business and to learn how to calculate free cash flow. Today we’re looking at what this figure is, why it’s so important, and how you can use it effectively.
What is free cash flow?
Free cash flow is the amount of money you actually have in the bank at the end of the month once you’ve paid off all of that period’s debts and expenses. Put simply, it’s how much money an organization has left over to spend on extras, improvements, and expansion.
Why is free cash flow important for your small business?
- It’s essential for growth – Free cash flow is what you have left over after paying expenses like salary, rent, and inventory costs. You need a sizable amount left over if you want to expand your operations in the future
- It’s an indicator of financial health – The companies with large cash reserves on the balance sheet are usually in much better shape than those with low reserves. Plus, it looks good on your financial statements and may even help attract investment
- It’s needed for emergencies – Your regular operational expenses aren’t the only costs you’ll need to contend with. It’s vital to have free cash flow on hand to cover any emergency situations
- It’s needed for fluctuations in business – Not every month is going to be exactly the same, and in some cases, you may even have seasonal peaks and troughs. Free cash flow is essential to ensure smooth operations
Limitations of free cash flow
- Low cash reserves don’t necessarily mean poor performance – While you might think that low cash reserves are a sign of a struggling venture, it could actually be the case that the company is investing its money in growth. You can’t use free cash flow as your only metric when considering business health and need to look at statistics in the round. This is even more true for brand new businesses
- Bad at predicting growth – Free cash flow on its own doesn’t really give an indication of the potential for future growth. You’ll need to look at long-term profitability to get a clear idea of this
- It’s not the best metric for investors – If you’re thinking of investing in a small business and just use free cash flows you might not get the full picture of how it’s covering its debts and payments
How to calculate free cash flow
Not every company prepares its cash flow statement in exactly the same way and there are three different ways to calculate the free cash flow figure to account for this. However, whichever method is used, it should always bring about the same final figure so organizations can’t game the system.
You can use operating cash flow, sales revenue, or net profits as your starting point and we’ve covered the calculations for each below.
Using operating cash flow
This is a very popular method used by many small businesses simply because it’s so easy to calculate. You might also see it referred to as the cash from operations calculation (CFO) figure. You only need two figures for the calculation, operating cash flow and capital expenses, both of which can be easily found on just about any financial statement.
Simply take the operating cash figure and deduct capital expenses from it to get your free cash flow figure.
Formula: Free cash flow = Operating cash – Capital expenses
Using sales revenue
To find your free cash flow figure using sales revenue you need to take your final sales figure and deduct all expenses used to generate those sales. This includes taxes and all operating expenses.
Next, you’ll need to deduct the cost of any investments in operating capital such as purchases of equipment. You can find this figure on your balance sheet. There are a few moving parts to this formula which is calculated as follows:
Formula: Free cash flow = Sales revenue – (Operating costs + Taxes) – Required investments in operating capital
You’ll need to consider a few other calculations to get the above figures including:
Required investments in operating capital = Year one total net operating capital – Year two total net operating capital
Total net operating capital = Net operating working capital + Net plant, Property, and Equipment (operating long-term assets)
Net operating working capital = Operating current assets – Operating current liabilities
Operating current assets = Cash + Accounts receivable + Inventory
Operating current liabilities = Accounts payables + Accruals
Using net operating profits
Using net profits is a very simple cash flow formula that is sometimes known as net operating profits after taxes (NOPAT). The formula is as follows:
Formula: Free cash flow = Net operating profit after taxes – Net investment in operating capital
Net operating profit after taxes = Operating income X (1 – Tax rate)
Operating income = Gross profits – Operating expenses
How to use free cash flow to grow your business
Having a positive free cash flow is not only a sign that your business is in excellent health, it affords you the opportunity to expand your operations. Large cash reserves mean that you can pour funding into profitable opportunities like an expansion of your premises, buying new equipment that’ll help create a new product line, purchasing more stock to cover a rush of orders, or funding a marketing campaign to bring in new customers.
In addition, a positive cash flow balance can encourage outside investment in your business as people will see your company as profitable and low-risk. Plus, you won’t need to rely on business loans and debt as much, although this too can play a useful role in your funding mix.
Being able to pay your bills each month with some cash left over is the primary goal of every business. Only those that properly manage cash flows will be able to do this, and being able to accurately calculate your free cash flow figure is essential.
You should always analyze your accounts and cash flow levels on a monthly basis at the very least, but you’ll get more value by looking at daily figures so you’re able to see any dangers ahead. A good piece of accounting software will keep you on track and ensure your cash reserves stay healthy.