Those familiar with the term "free cash flow," have typically encountered it in use with regard to investing. Free cash flow, however, is also an integral measurement tool in management accounting. This metric allows business owners, managers and board members to measure and monitor a company's present value to track growth, encourage expansion and avoid failure.
What is Free cash flow?
The simplest definition of free cash flow is the amount of leftover money in a company. Free cash flow is the amount of cash (operating cash flow) which remains in a business after all expenditures (debts, expenses, employees, fixed assets, plant, rent etc.) have been paid. Free cash flow represents a company's current cash value (not considering growth potential).
Cash Flow Versus Free Cash Flow – How Are They Different?
Although they sound similar, the two are quite different.
- Cash flow is the flow of cash coming in and going out of a business over a certain period of time. It is presented in a cash flow statement.
- Free cash flow represents the amount of disposable cash in a business (remaining after all expenditures). Sometimes, free cash flow is considered to be a company's current cash value. Though, since it does not take into consideration a business's growth potential, it is not normally considered a business valuation.
How to Calculate Your Company's Free Cash Flow
Free cash flow (FCF) equals cash from operations (CFO) minus capital expenditures (CapEx).
FCF = CFO – CapEx
Although the equation appears simple, free cash flow can be a daunting metric to calculate because you must first calculate your company's cash from operations and determine its capital expenditures, using information from your company's balance sheet and/or cash flow statement.
Cash from Operations
First, you must determine your company's cash from operations.
CFO = Net Income + Non-Cash Expenses +/– Change in Non-Cash Net Working Capital
These are all of the items (adjustments) on an income statement which do not actually affect cash.
Non-Cash Expenses = Depreciation + Amortization + Gains/Losses on Investments + Stock-Based Compensation + Impairment Charges
Change in Non-Cash Net Working Capital
Accurately calculating this change can be tough. Accounts receivable (AR), accounts payable (AP) and inventory are the three items which most commonly affect fluctuations in net working capital.
Change in Non-Cash Net Working Capital = (Current Period AR – Prior Period AR) + (Current Period Inventory – Prior Period Inventory) – (Current Period AP – Prior Period AP)
Finally, you must determine the company's capital expenditures. You can do so with line items (Property, Plant and Equipment (PP&E), depreciation and amortization) from the company's balance sheet.
CapEx = Current Period PP&E – Prior Period PP&E + Depreciation + Amortization
Put It All Together to Determine Free Cash Flow
As you can see, the equation for free cash flow is quite cumbersome.
Free Cash Flow = Net Income + (Depreciation + Amortization + Gains/Losses on Investments + Stock-Based Compensation + Impairment Charges) – ((Current Period AR – Prior Period AR) + (Current Period Inventory – Prior Period Inventory) – (Current Period AP – Prior Period AP)) – (Current Period PP&E – Prior Period PP&E + Depreciation + Amortization)
Typically, this single equation is simplified by calculating each of its components separately. So, the commonly accepted equation for free cash flow is:
Free Cash Flow = Cash from Operations – Capital Expenditures
Free Cash Flow Compared to Other Valuation Metrics
- Free Cash Flow to Equity (FCFE) - This metric is basically free cash flow adjusted for debt. FCFE measures the equity value of a company, in other words the amount of money available to equity shareholders after paying all expenses, debts and reinvestment costs.
- Free Cash Flow to Firm (FCFF) - FCFF describes a company's enterprise value, or the amount of cash available through both debt and equity.
- EBITDA (Earnings before Interest, Taxes, Depreciation and Amortization) - One of the metrics more commonly used to discuss and compare business valuations, EBITDA reflects a company's value apart from its finance and accounting decisions. Basically, EBITDA is calculated by adding interest, taxes, depreciation and amortization back into net income. EBITDA uses accrual accounting, which means the metric gives lots of weight to the decisions and expectations of a company's management and board.
Although these can all be useful metrics in valuing a company, free cash flow provides the most accurate and objective estimate of a company's present value, the cash leftover.
Use Your Free Cash Flow to Grow Your Business
Free cash flow is a number usually discussed from the perspective of investors. Free cash flow, however, is also an important number for business owners – even those who are not looking to raise capital by selling equity. Positive or negative free cash flow can sometimes indicate a company's health.
By tracking your company's free cash flow, you can also measure your business's growth and success. Owners of companies with consistently positive free cash flow enjoy a multitude of options regarding how to use the leftover money.
Free cash flow can be used to expand operations, bring on additional employees or invest in additional assets, and it can be put toward acquisitions or paid out in dividends to shareholders. Having too much free cash flow, however, can indicate that a business is not properly leveraging its assets, as excess funds could be put toward expansion.
On the other hand, the owner of a business with negative free cash flow should evaluate why FCF is negative. If the business has negative free cash flow because "extra" money is consistently reinvested for growth, then the negative number is a reflection of that growth strategy. When cash flow shortages are to blame, however, negative FCF could be a cause for concern.
A business owner, plagued with negative free cash flow as a result of a cash flow shortage, might need to restructure operations or raise capital by taking on additional debt, selling equity or investing personal funds.
Businesses can also increase free cash flow by:
- Restructuring debt to lower interest rates and optimize repayment schedules.
- Reducing, limiting or delaying capital expenditures.
- Hiring a CFO, or fractional CFO to improve financial strategy and business operations with management accounting.
In addition to monitoring their income statements, balance sheets and cash flow statements, business owners can use free cash flow to take the temperature of their businesses, measure growth and make data-driven decisions to drive profits.