What is Free Cash Flow?
Businesses survive and thrive on cash. Cash allows businesses to take risks, seek new opportunities, and to strengthen their financial statements. Generating cash requires professional expertise.
While most businesses have actual cash, the problem is determining how much of this cash is needed to pay vendors and employees? How much is tied up for equipment purchases?
Without free cash flow, a business will either cease to exist or be bought out by a competitor. Regardless of industry, free cash flow is crucial to survive, grow, and prosper.
In this post I’ll define free cash flow, show an example of free cash flow, and provide tips to consider when analyzing free cash flow in your company.
What is Free Cash Flow?
In the business world, free cash flow (FCF) is cash generated by operations after expenditures for capital assets. It represents the cash leftover after operation and capital expenses have been paid—the excess cash that can be spent on other projects, ventures, or opportunities.
Formula for Free Cash flow
The formula for free cash flow is calculated as follows:
FCF = Cash From Operations – Capital Expenses
The free cash flow formula starts with the cash from operations from the cash flow statement. Then removes any of the capital expenses paid with cash for the same period.
If your CFO does not produce a cash flow statement you can still calculate FCF, you just have a couple of extra steps to go through first.
FCF = Net income + non-cash expense – increase in working capital – capital expenditures.
This formula is a way to manually calculate the cash from operations. While this way should get you the same answer, it is susceptible to errors by omission.
It is not uncommon to forget about loss on sale of equipment, or accretion on a retirement asset, etc. If you use this formula be aware of the possibility of errors if you forget to include those points.
FCF is important to an organization because:
- It allows room to make mistakes.
- It’s a barometer on the health of the organization
It allows room to make mistakes.
Business owners make operating decisions every day. These decisions are geared towards a specific goal.
Sometimes those goal revolve around expansion of a plant, moving into a new market, or possibly purchasing a competitor. These decisions many times come with risk.
A business owner will be less likely to take a risk if they know there is no room for a mistake. Having FCF allows the owner to take a risk.
If the risk doesn’t pan out, then they are still able to operate under the current model. Understanding how much free cash flow is available makes taking risks more palatable.
A barometer on the health of the organization.
Net income is sometimes considered the gold standard for determining the health of a company. But what if some of that revenue won’t be collected until next year? What if some of the revenue is false or posted in error? What if certain assets have been capitalized and incorrectly made the company profitable?
The FCF model flushes out all these accrual items and gives a true picture of the cash position. Vendors, employees and owners are paid with cash, and not by a journal entry.
The free cash flow eliminates all the accrual ‘noise’. Companies run on cash and knowing how much is available is key to the strategic survival of any organization.
Example of Free Cash Flow
In this example, FCF represents the blue continuous line. As you can see, the FCF will fluctuate each month.
In the month of April 2019, the FCF went negative even though there was roughly $12,000 of cash on hand. The FCF calculation will alert management the need to focus on what is happening to the overall cash position.
Understanding that FCF is negative when there is cash is on hand will allow management the ability to adjust operations to prevent any further issues. In this example the FCF reversed itself the following month.
However, a continuous trend in negative FCF can be devastating for a company if not caught quickly.
What can cause negative FCF?
Negative cash flow can be a significant issue for smaller companies. The first reaction to negative cash flow is due to poor operations.
When operations are not funding the company, the negative needs to be filled from another part of the financial statements. Usually it comes from loans or more capital infusion.
The more costly of these paths is to pull on loans. To catch this pattern, companies need to focus on FCF each month.
Another aspect that causes negative FCF is capital purchases. For asset intense businesses, such as oil and gas extraction, the negative FCF may be due to a management decision. In these types of businesses, management has made the executive decision to purchase more equipment believing they will produce more revenue in the future.
Tips and Reminders for Free Cash Flow
- Calculate the FCF every month and keep at least a 24-month rolling graph. Some months the FCF will go negative. Keep an eye on a continuous negative trend to prevent severe consequences to the company.
- Remember that a cash management strategy, such as delaying paying accounts payable, could skew the FCF calculation. Understand all current strategies when analyzing the FCF.
- Excess FCF allows the owner the ability to make mistakes.
Businesses need cash to survive. Calculate the FCF monthly to make sure your business can survive and react to cash flow needs. Bringing on a fractional CFO is a great way to ensure you have monthly FCF calculated correctly.
Steven D Hovland is a Certified Public Accountant and a Certified Forensic Accountant. He has 20+ years of experience in auditing, accounting, and forensic investigations. He is the founder of Hovland Forensic and Financial, a virtual CFO service company as well as forensic litigation services.
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