Free Cash Flow

Understanding the financial position of a company, be it your own or one you’re comparing yourself with, requires a strong understanding of a series of financial terms.

It’s not enough to simply consider how much money the company has in its coffers or what its stock price is today.

To really get a sense of how well an organization is doing, we want to analyze earnings in the context of the other half of the equation: expenses.

This is why finance leaders, business owners, and investors use a term known as free cash flow, a calculation of the cash an organization generates after taking into consideration all cash outflows.

In this guide, we’re going to take a good hard look at free cash flow to understand why it’s a helpful metric for your business to track:

What Is Free Cash Flow (FCF)?

Free cash flow is the amount of cash a company has generated after considering cash outflows for the period.

In this case, we’re considering cash outflows for both operating expenses (OpEx) and capital expenditures (CapEx).

In short, we’re trying to find out how much cash a business actually made after spending a portion of its revenues on the things it needs to not only operate but to expand and grow.

With all of these outgoings now accounted for, FCF is essentially the money a company has left over to use as it pleases, such as to pay down loans or pay out dividends to its investors.

Also read: Free Cash Flow Margin and Free Cash Flow Yield

Levered FCF vs. Unlevered FCF

Some financial leaders and investors choose to break down the FCF metric into two subcategories:

1. Levered FCF
2. Unlevered FCF

The simple difference between the two is that levered cash flow is FCF after the business has met its financial obligations, and unlevered FCF is free cash flow measured before paying down financial obligations.

Some organizations will include both on their balance sheet, though levered free cash flow is typically of more interest to investors, as it provides better insight into the amount of cash the business has available to expand or to pay out to stockholders.

However, it can be useful to analyze the two figures side by side, as the difference between levered and unlevered free cash flow demonstrates how many financial obligations the organization has and whether or not the company is overextended.

How Is Free Cash Flow Calculated?

There are a few different ways you can calculate free cash flow (three, to be specific). The method you choose will depend on the financial statements and accounting methods you use.

In any case, you should arrive at the same result with whichever formula you choose to use.

Calculating Free Cash Flow Using Operating Cash Flow

The first option for calculating free cash flow is to start by using your operating cash flow.

This is the most common approach because it’s super simple and uses two figures that you’ll pretty much always find in your existing financial statements:

1. Cash flow from operating expenses (found on the cash flow statement)
2. Capital expenditures (found on the balance sheet)

Here, you’re simply going to subtract capital expenditures from net operating expenses:

Free cash flow = Cash flow from operating expenses – Capital expenditures

Calculating Free Cash Flow Using Sales Revenue

Option two is to begin with your sales revenue for the period and then subtract the expenses that were associated with generating that income.

You’ll need your income statement and your balance sheet for this one.

First, grab your total revenue from the income statement, and subtract all taxes and operating costs (such as cost of goods sold and administrative costs).

Then, subtract your net investments in operating capital (found on the balance sheet) to arrive at your FCF figure.

Here’s the formula for this method:

Free cash flow = Sales revenue – (Operating costs + Taxes) – Net investments in operating capital

Calculating Free Cash Flow Using Net Operating Profits

Your last option for calculating free cash flow is to begin by using net operating profits.

The net operating profits figure already accounts for your operating expenses and taxes, meaning you’ve essentially already taken care of the first step in the above method.

So, this free cash flow formula is pretty straightforward:

Free cash flow = Net operating profit after taxes – Net investments in operating capital

Why Is Free Cash Flow Important For Businesses? How To Interpret FCF

Understanding free cash flow (and how to analyze it) is critical for good cash management.

At its core, FCF shows how efficient an organization is at generating cash. The more free cash flow a business has, the more prepared it is to pay down its debts, pursue growth opportunities, or make payments to investors in the form of dividends.

For investors, it helps with insight into a company’s financials, allowing them to make more informed investment decisions. As a founder or finance leader, it’s important to know how potential investors will use this information to decide whether or not to invest in your company.

Investors view higher FCF as a good signal that the business might be able to engage in share buybacks or pay out desirable dividends.

That said, declining free cash flow isn’t always a bad thing.

Consider, for example, that a company is continuously increasing its investments in capital expenditure. This is going to drive FCF down but is in itself a good signal that the company is invested in long-term growth and has a strategic plan to deliver on this objective.

This is actually one of the drawbacks of using free cash flow as a measure of financial health. Investments in capital expenditure can vary dramatically from period to period, as these tend to be large one-off expenses.

For this reason, it’s a good practice to view free cash flow metrics not in a vacuum but as a trend over time.

If FCF is growing, this is commonly a signal of increased future earnings for investors.

Whether the new free cash flow is coming from improved efficiency, reductions in costs, or simply greater revenue, it’s likely that the company will be able to engage in investor-rewarding activities later, like increased dividends.

Of course, it could also signal that the company isn’t sufficiently investing in future growth (such as updating plant and equipment), so it’s important to examine not only the headline FCF metric, but the components that make it up.

Potential investors find companies with growing FCFs but lower share prices desirable, seeing this as a good sign that earnings and share prices will soon increase.

On the other hand, if free cash flow is decreasing over time, it may be a signal that the business is unable to sustain long-term growth in earnings. To validate this notion, investors must dig a little deeper.

Primarily, they’ll want to know if FCF is shrinking because of increased capital expenditures, reductions in revenue, or increased exposure to debt.

Also read: Cash Flow vs. Earnings: What’s The Difference?

Monitor Changes In Free Cash Flow Using Finmark

Free cash flow is one of a number of incredibly important financial metrics that help investors, founders, and finance leaders interpret and understand the financial health of a company.

By analyzing and understanding a company’s free cash flow, you can determine whether there is a likely increase in future earnings, whether the business is effectively creating cash from its operating activities, and how it’s investing in future growth.

As we’ve seen, however, it’s important to not only view the FCF value itself but to analyze it in the context of longer-term changes, as well as the components that make it up (operating expenses and capital expenditure).

To really get a handle on free cash flow, you’ll want to set this up as one of the key metrics in your financial modeling platform.

Finmark from BILL allows founders and finance professionals to integrate their various financial and accounting tools, create custom reporting dashboards for further financial analysis, and even model various scenarios to understand the potential future impact of capital expenditure decisions.

Start making smarter, more strategic financial decisions today with a free 30-day trial of Finmark.