The formula for free cash flow (FCF) is one every business owner should learn how to use. When you know how much cash is coming in and flowing out of your business, you can make better decisions about where and how to invest your company’s money. The free cash formula is an effective method for calculating the value of a business. It has been keeping organizations solvent for years, but few know about it.
In this article, we’ll explain what the free cash flow formula is and show you how to calculate it.
What is Free Cash Flow (FCF)?
Even if you’re not a financial whiz, you’ve probably heard of free cash flow (FCF), the term for the amount of cash a company has left over after paying its bills and making investments. But what does it mean for small business owners?
Free cash flow FCF is the money left over after subtracting the cost of capital spending from operating income. Capital spending is how much a business spends to keep its factories, machinery, and other assets working at peak performance. It includes new equipment, buildings and software as well as more intangible costs such as research and development (R&D).
FCF is important because it is one of the key metrics investors use to determine how much money a company has available to use for other purposes. For example, if a business can generate more than enough FCF to cover its debt payments and dividend payments, then it will have excess cash on hand. This means it can use that money to buy back shares or pay down debt.
Example of FCF
Cash flow is one of the most indispensable elements of any business, and it’s a metric that is easy to calculate.
Cash flow is the amount of money a company has left over after paying all its expenses. When you look at cash flow from one period to the next, you can see how much money the company has available to pay back investors, expand operations, and make other investments in growth.
In order to calculate cash flow, you need to start by looking at revenue and then subtracting all of your expenses. This formula is called free cash flow (FCF) because it is essentially “free” money—the amount of money left over that isn’t tied up in investments or debt obligations.
Let’s look at an example: Company ABC makes $50 million in revenue during their first quarter; they also have $10 million in expenses (including rent, payroll costs, and utilities). That leaves them with $40 million in free cash flow for that quarter—money they can use to pay back investors or expand into new markets!
There are several potential causes that can impact free cash flow, including:
Investing in Growth. When a business invests in growth or expansion through new product development or acquisitions, this can reduce its free cash flow. This is because these types of investments usually require upfront costs that must be paid before they generate revenue.
Stockpiling Inventory. You might also find that your company has too much inventory or raw materials on hand and is using up some of its free cash flow to pay for these items. As a non-cash expense, this can happen if you have been selling less than expected or if there has been an issue with production at your facility.
Credit Problems. If a company’s credit rating is poor or if they have trouble paying their bills on time, this will result in higher interest rates for loans or worse terms from suppliers or customers. This reduces free cash flow because these additional costs must be paid before funds can be used elsewhere in the business.
How to Calculate Free Cash Flow (FCF)
There are three ways to calculate free cash flow: using operating cash flow, using sales revenue, and using net operating profits.
Using Operating Cash Flow
This method uses the amount of money generated by your company after paying all operating expenses. This includes salaries, rent/mortgage payments, taxes (both federal and state), insurance premiums, and any other costs associated with running the business.
Using Sales Revenue
Sales revenue is also used to calculate free cash flow. It’s the total amount of money brought in through sales minus the cost of goods sold (COGS). COGS includes all the expenses incurred during production, but does not include taxes or interest paid on loans or other debt. Sales revenue includes COGS because this number indicates how much profit the company will earn after paying those expenses.
Using Net Operating Profits
Net operating profit is basically just your gross profit minus expenses like depreciation and amortization (if they apply). It doesn’t include interest expenses or taxes paid because those costs aren’t related to how much money you make from selling products or services. If you don’t have enough information on these other expenses or if you are a startup company without any revenues yet, then calculating net operating profit may be impossible for now!
Each method has its advantages and disadvantages, so it is important to choose one that is right for your situation.
Benefits of Free Cash Flow
Free cash flow is a good indicator of how a business will perform over time because it shows whether or not the company has enough money to invest in new projects or pay dividends to shareholders.
The benefits of free cash flow include:
- It’s easy to understand and compare with other companies’ free cash flow numbers.
- It lets you see how much money is coming in, which can help you project future profitability.
- It helps you understand how much money a company has available for expansionary projects.
- It gives you an idea of how much debt your company has and whether that debt load will increase or decrease over time.
Limitations of Free Cash Flow
Free cash flow has become an important way for companies to evaluate their performance because it shows whether they are generating enough money to meet their obligations and grow their business.
However, there are limitations to free cash flow:
- It does not account for taxes or non-cash expenses, such as depreciation and amortization.
- It does not account for changes to working capital.
- It does not consider the timing of cash flow over time.
- It only measures cash flow from operations, which may not reflect the true economics of an organization.
How to Derive the Free Cash Flow Formula
When you are looking at the cash flow of a company, it can be helpful to know how to calculate free cash flow. If you are trying to figure out whether a company will be able to pay its bills and stay in business, or if you are trying to find out how much money is available for dividends to shareholders, free cash flow is an important metric.
The formula itself is quite simple, but it can be a little confusing if you are not familiar with all of its variables. Here is how to derive the free cash flow formula:
Cash From Operations and Net Income
The Cash Flow Formula is calculated by taking the net income of a business and subtracting all costs associated with operations. The result from an income statement is a figure that represents the amount of money that was actually available for use after all operating costs were paid.
The formula for Cash From Operations (CFO) is:
CFO = Net Income + non-cash expenses – increase in non-cash net working capital
Non-Cash Expenses
Non-cash expenses are expenses that don’t require the purchase of actual inventory, equipment, or other physical assets. They are usually listed as intangible assets on a company’s balance sheet, including depreciation and amortization, stock-based compensation, impairment charges, and gains/losses on investments.
The formula for non-cash adjustments is:
Adjustments = depreciation + amortization + stock-based compensation + impairment charges + gains/losses on investments
Changes in Non-Cash Net Working Capital
The key to calculating free cash flow is understanding how to incorporate changes in non-cash working capital into your calculations.
Non-cash working capital is the amount of cash that a company has tied up in inventory, accounts receivable and other assets. This can include accounts receivable, inventory, and accounts payable.
When you calculate free cash flow, you want to make sure that you don’t count changes in this non-cash working capital as actual cash. Instead, you want to subtract the change from your FCF calculation and add it back into your FCF calculation at a later time when the money actually gets spent.
The formula for changes in non-cash working capital is:
Changes = (2022 AR – 2021 AR) + (2022 Inventory – 2021 Inventory) – (2022 AP – 2021 AP)
Where,
AR = accounts receivable
AP = accounts payable
2022 = current period
2021 = prior period
Capital Expenditures
Capital expenditures (CapEx) is the amount a company spends on fixed assets, such as property and equipment. The amount of capital expenditures is calculated by subtracting depreciation from total investments. CapEx can also refer to any expenditure that does not directly result in revenue generation but instead contributes to the long-term growth of a company’s assets, such as research and development costs or advertising expenses.
Free cash flow is calculated by subtracting capital expenditures from operating cash flow (OCF). Capital expenditures are expenses related to purchasing or upgrading physical assets, such as buildings or machinery.
For example, if Company X has a net income of $100 million and makes $50 million worth of capital expenditures, its free cash flow would be ($100 million – $50 million) + $0 = $50 million.
If you subtract the capital expenditure from net income before adding back the dividend payment, then you are using “operating” free cash flow rather than “adjusted” free cash flow. The two measures are similar but not identical: operating free cash flow includes operating costs such as depreciation and amortization, while adjusted free cash flow does not include those costs but does include interest expenses (which are excluded from operating costs).
The formula for capital expenditures is:
CapEx = 2022 PP&E (property, plant, and equipment) – 2021 PP&E + Depreciation & Amortization
Combining the Components Of the FCF Formula
If you were to combine the above four steps into one formula, it would be equal to:
FCF = Net Income + [depreciation + amortization + stock-based compensation + impairment charges + gains/losses on investments] – [(2017 AR – 2016 AR) + (2017 Inventory – 2016 Inventory) – (2017 AP – 2016 AP)] – [2017 PP&E – 2016 PP&E + Depreciation & Amortization]
or
FCF = Net Income + Non-Cash Expenses – Increase in Working Capital – Capital Expenditures
The simplified formula is:
FCF = Cash from Operations – CapEx
Levered and Unlevered Free Cash Flow
Levered and unlevered free cash flow are two different metrics that can be used to evaluate the financial health of a company.
Levered free cash flow is the amount of cash available for a company to use after taking into account the cost of funding its operations. This is calculated by deducting net debt from EBITDA (earnings before interest, taxes, depreciation, and amortization) plus non-cash charges.
Unlevered free cash flow is also calculated by deducting net debt from EBITDA plus non-cash charges. However, in this case, it does not take into account how much debt would be added to the balance sheet if they were to borrow money or issue more equity.
The Bottom Line
Free cash flow is an excellent financial metric for determining a company’s health and growth potential. This formula is one of the best ways for small business owners to evaluate where they stand in their business, which can be helpful for making important strategic decisions.
What’s more, the free cash flow formula is not just for use as an evaluation metric. You will also find it useful for building a business plan, creating a new financial model, and more. It is a handy financial formula to know, and with the help of this guide, you can get familiar with it in no time.
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