How Is Free Cash Flow Calculated?

Why Is It Important To Calculate Free Cash Flow?

Free Cash Flow matters for you, your team, investors and lenders, and potential lenders or partners.

For investors and creditors, FCF is a vital metric that helps assess a company’s ability to generate cash and fund its operations independently. It’s also an essential tool for internal management to evaluate the efficiency of their business operations. The metric also indicates a company’s ability to generate sufficient cash to support activities, invest in growth, pay dividends, and reduce debt. Overall, free cash flow acts as a barometer for financial health and efficiency.

Strategic Decisions Based on Free Cash Flow

FCF is often used to make critical decisions within your business, such as which projects to prioritize, when to pay dividends, or whether to buy back shares. Companies with strong FCFs are usually better positioned to spend without ending up in high-risk territory.

How To Find Free Cash Flow: What You Need

While it’s not a line item directly reported in financial statements, you can easily calculate your free cash flow using data you already have. You’ll need an income statement and a cash flow statement for the calculation.

The income statement provides insight into a company’s revenues and expenses, while the cash flow statement offers a detailed view of the cash inflows and outflows from operating, investing, and financing activities. Combining these data points makes calculating your FCF a breeze.

How To Calculate Free Cash Flow: The Formula

The formula for calculating FCF is straightforward yet insightful:

Free Cash Flow = Operating Cash Flow – Capital Expenditures

Here’s a brief breakdown of the formula:

• Operating Cash Flow: This is the cash generated from your company’s normal business operations. It’s found on the cash flow statement and reflects the cash inflows and outflows related to core business activities.
• Capital Expenditures (CAPEX): These are the funds your company uses for the acquisition and maintenance of physical assets. This group could include expenses for purchasing new equipment or buildings or investing in new technologies.

How Is Free Cash Flow Calculated? An Example

Let’s say a company has an operating cash flow of $500,000 and capital expenditures of $200,000. The FCF would be $500,000 – $200,000 = $300,000. This means that after accounting for the investments needed to maintain or expand its asset base, the company has $300,000 available for other uses.

What to Do With Your Free Cash Flow Calculation

FCF is a dynamic financial metric that gives you a clear sense of your company’s financial health. Positive FCF indicates that your company has enough funds to maintain its operations and assets while pursuing growth opportunities, paying dividends, or reducing debt. On the other hand, negative FCF often points to challenges in generating sufficient cash. Use your free cash flow results as a signpost for your next steps — either maintaining your course or correcting it.

The Limitations With Free Cash Flow

Despite its usefulness, FCF has limitations. One key issue that limits FCF is that it doesn’t account for the cash needed for mandatory debt repayments or dividend payments. That means that even if your company has a high FCF, you might have little free cash available after covering these obligations. Keep debt in mind whenever you calculate your FCF.

Potential for Misinterpretation

Without expert assistance, you also risk misinterpreting your FCF. For example, a high FCF could result from a company delaying necessary spending, which might not be sustainable in the long run. In addition, FCF doesn’t provide a complete picture of a company’s profitability or operational efficiency. Instead of looking at the metric as all you need, use it alongside other financial data for best results.

Can a Company Have a Negative Free Cash Flow?

Companies end up with a negative FCF for several reasons. Making large investments in capital expenditures or facing operational challenges that reduce cash flow are some of the most common factors that make a company’s FCF worse. While negative FCF is usually a cause for concern, especially if it persists over multiple periods, it’s not inherently a sign that your company is headed for failure. Sometimes, a negative FCF just means your business is growing or transitioning.

Evaluating Negative FCF

You know how free cash flow is calculated, but you also need to know what to do when your results indicate a negative FCF.

When evaluating a company with a negative FCF, we always pay attention to the context. For instance, if the negative FCF stems from large investments with the potential for significant returns in the future, it might be a positive sign. However, if it’s due to declining sales or increasing costs, a negative FCF is a definitive warning signal.

Why Look To TGG for Help?

Mastering the concept of Free Cash Flow is a fundamental aspect of business finance. It provides valuable insights into a company’s operational efficiency, financial health, and growth potential. However, FCF is just one piece of the financial puzzle, and you should analyze it in conjunction with other metrics for a complete financial assessment.