Free Cash Flow Margin

Being able to generate free cash flow is one of the most important indicators of running a profitable and self-sustaining business.

Taking this one step further, your free cash flow margin is a key profitability metric that both internal and external stakeholders can use to gather insights about the business.

So, it’s probably a good idea to have a solid understanding of where your FCF margin currently stands and the insights it provides.

Here, we will explain what your free cash flow margin is, how to calculate it, and what it can tell you and investors about your business.

What Is FCF Margin?

Free cash flow (FCF) margin is a measure of profitability for a business. FCF Margin takes the free cash flow that a business generates and compares it against the revenue they earned during the same period.

In other words, this metric shows the amount of revenue that is converted into free cash flow.

As a reminder, free cash flow is the cash that companies generate from operating activities, minus what was paid for capital expenditures.

It’s what’s left for financing activities like paying dividends, debt repayments, or share buybacks.

Free Cash Flow vs. Cash Flow

It’s important to make the distinction here between free cash flow and cash flow.

While similar, these two measurements slightly differ by definition, so they are not interchangeable when calculating FCF margin.

Cash flow is the total cash that your business used or generated during a given period. This calculation combines the total cash flow from operating, investing, and financing activities.

Free cash flow, on the other hand, centers around the cash flow generated by operating activities and what was paid for capital expenditures (part of investing activities).

Given the overlap between cash flow and free cash flow, these figures are highly correlated with one another.

But, you need to be sure that you’re utilizing your free cash flow to calculate your free cash flow margin, and not substituting it with total cash flow–which would still offer important yet different insights.

How to Calculate FCF Margin

Free cash flow margin isn’t something that you’ll typically find listed on your main financial reports. But, you just need to utilize a few items from your income statement and cash flow statement to calculate it.

As stated above, FCF margin is the free cash flow you generated for a given period, expressed as a percentage of your revenues.

FCF Margin = (Operating Cash Flow – Capital Expenditures)/Total Revenue x 100

Breaking this down further, your operating cash flow is taken directly from the operating section of the cash flow statement.

This value is typically calculated starting with the net income reported on the income statement and is adjusted for non-cash items like depreciation or amortization expense to determine the amount of cash that your core operations provided or used during the period.

Capital expenditures refer to the purchases that the company makes to acquire, upgrade, or maintain physical assets like property, plant, and equipment (PPE). This figure is demonstrated in the investing section of the cash flow statement.

The total revenue is taken from the first line of the income statement.

You can calculate your FCF yield by hand, or use Finmark’s custom formulas to quickly calculate this metric using the most up-to-date financial data available on your company.

FCF Margin Example

Let’s assume that a company had an operating cash flow of $47,000 for the second quarter of this year, and they spent $12,000 on capital expenditures to purchase a new piece of equipment.

During that period, their total revenue was $230,000.

To find their free cash flow margin, we first subtract the capital expenditures from the operating cash flow to find the free cash flow:

$47,000 – $12,000 = $35,000

Then, we take the free cash flow and divide it by the total revenue for the period to get the FCF margin:

$35,000 / $230,00 = .152

Multiply this value by 100 to get the FCF margin in percentage terms:

.152 * 100 = 15.2%

So in this example, the business had an FCF margin of 15.2%. Generally, the higher the FCF margin, the better, but we will touch on this in more detail later.

Why Should Businesses Care About FCF Margin?

You should be aware of your FCF margin because it is a key indicator of how efficiently your business is able to turn revenues into free cash flow.

With free cash flow, you can reinvest in the company, repay your debts, or pay out dividends to shareholders.

Analyzing the free cash flow margin can also show you how dependent the company is on capital expenditures to fuel revenues as opposed to your core operations.

Essentially, even if you are generating a good amount of revenue, the free cash flow may not follow suit if you’re heavily spending on operating expenses or new equipment. These are the types of insights that you can find from calculating your FCF margin.

So, frequently monitoring your free cash flow margin will provide you with a different lens to assess your revenue growth.

It can help you see how sustainable your investments in PPE are, and whether or not your revenue growth is resulting in more cash for you to reinvest in the business or return to investors and creditors.

What Does Your FCF Margin Say About Your Business?

By calculating the FCF margin for your company, you’re able to see how much free cash flow is generated for each $1 of revenue.

Again, the higher the FCF margin, the better. This means you have capital on hand to deploy even after taking care of your current financial obligations. It shows you were efficient in turning revenues into cash that could be spent on financing activities.

As you could assume, a lower FCF margin would indicate that there is less cash available to reinvest in the business or pay back your debts, and you weren’t as efficient with your revenue.

Plus, it’s not unheard of for businesses to generate a negative free cash flow, which would likely result in a negative FCF margin.

If this is the case for your business, it signifies that you couldn’t support your core operations or investing activities by using what was generated from operations.

Experiencing negative FCF while in the growth stages is normal for more capital-intensive businesses. But, prolonged negative FCF or FCF margin is typically a warning sign that operations are unsustainable.

Why Do Investors Care About FCF Margin?

When evaluating your business, investors will also look into your FCF margin.

So aside from it being an important metric to track internally, it will often be of interest to possible investors and creditors as well.

If investors provide you with capital, they want to know that they will be able to recoup their investment.

Analyzing the FCF margin is one of the ways that they can evaluate this likelihood. This metric can help them determine how efficient you are with your resources, a major point of interest for investors.

Taking one step back, free cash flow itself is a measure of how much cash the business has on hand after taking care of its operating and investing needs.

Put differently, it shows investors how much cash the business has left to deploy via:

• Dividends
• Debt repayments
• Share buybacks
• And more

So, investors want to see that your company can effectively turn revenues into free cash flow that they can benefit from.

Top-line revenue growth is a headline metric that shareholders, creditors, internal stakeholders, and others pay attention to.

But, just because revenue is growing doesn’t always mean that investors will see a greater return.

If investors see that your company is putting large sums of money into operating expenses or capital expenditures in order to drive revenue growth, there will likely be a lower FCF margin as a result, or less money on hand for them to receive through dividends, debt repayments, and more.

All in all, investors will typically analyze your FCF margin alongside other important metrics like gross margin, ARR, and revenue churn, to get a more complete view of your business’s financial standing.

Start Measuring Your FCF Margin Today

Having a good grasp of your free cash flow margin will help you gauge how effectively you can turn your revenues into free cash flow.

When you’re ready to gain better visibility into your FCF margin, use Finmark as an intuitive and straightforward financial planning tool that you can customize to fit your needs.

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