Cash flow. We all look at this number on a personal level when we set up our personal budgets. How much income do we have coming in each month, what our bills are, and how much we have left over to do other things? Usually, you can estimate the exact figure.
Your business is no different. Every month you are generating a certain amount of income (revenue). You also have expenses and maybe even some debt. Finally, you have some money left over that allows you to do other things e.g. buy new equipment, invest in marketing or hire new employees. And it is usually called “free cash flow.”
A Quick Cash Flow Definition
A short and easy definition of a company’s free cash flow is this:
Cash flow is the amount of money you have left, once you have paid all of your expenses – salaries and benefits (even your own), rent, utilities, equipment, supplies, other costs of goods sold, taxes, debt repayment, etc.
Cash flows can be listed as positive or negative and are an important factor when considering the health of a company. This number may be especially interesting to potential investors or borrowers. And as a business owner, it’s best to know that figure too if you plan to re-invest in your company and scale your business.
A positive cash flow means that you do have extra money left over at the end of an accounting period. A negative cash flow balance at the end of a single reporting period, however, is not necessarily a bad thing. Perhaps during that period, the business owner chose to invest in significant growth of some sort – launching new products or opening up a new distribution center, for example.
It is when free cash flow is negative over several reporting periods, and that significant re-investment in the company has not occurred, that there should be some grave concern. If that’s the case, you should learn more about different cash flow management techniques.
Finally, there’s free cash flow – money you can use as you please as a business owner.
How to Calculate Free Cash Flow
Now that you know what is free cash flow (FCF), you need to understand how to estimate the dollar equivalent of it. Again, we’d like to strengthen how critical this figure is. Think about your own personal budget. If you do not know how much you have left over at the end of the month, after all of your expenses, how do you know what you can spend on a trip or set back for a long-term remodeling job or put into savings for a down payment on a home?
While some may tell you that calculating free cash flow is just too complex and requires a lot of effort, it’s not the case. All you need to know are the variables that are involved in the free cash flow formula.
Sales Revenues – Operating Costs and Taxes – Required Investments in
= Free Cash Flow
Now, let’s take a closer look at each of the elements of this formula.
Your Sales Revenue. This figure should already be on your income statement. It is the total that you took in as a result of your sales.
Operating Costs and Taxes. Your operating costs are all of the expenses related to the operation of your business – all of those costs that keep you in business – salaries, COGS, purchase of raw materials, rent, utilities, etc. – and, of course, the corporate taxes you must pay.
Required Investments in Operating Capital. This is any money you have had to put into your operations – new equipment, repairs, a warehouse expansion, etc. Your accountant will identify these things for you, and they, of course, must be subtracted from your revenue. You took in money and you spent some of it to keep things going.
What is left after all of your operating costs and required investments have been tabulated is your free cash flow.
Do Not Confuse Free Cash Flow with Net Profit
It’s easy to think, “Well, the cash flow that I have at the end of a reporting period is the same as my net profit or net income.” But, from an accounting standpoint, the two figures represent very different things.
Net profit is what income you have left after all expenses have been subtracted from your gross income. Cash flow refers to the amount of money you have coming in and going out during a reporting period. If you have more coming in than going out, you have a positive cash flow.
Let’s illustrate this further with a quick example:
Bill makes furniture and distributes it to retailers throughout his state. In the quarter that just ended, his gross sales totaled $100,000 (what retailers paid for his furniture). His operating costs and taxes totaled $40,000, bring the initial figure down to $60,000. His required investments in operating capital totaled $25,000.
He now has $35,000 remaining, which is his free cash flow. He can then choose to pay out some of that money as a bonus to himself, or put them aside for the next period.
The Point of Calculating Free Cash Flow
A positive free cash flow figure generally says a company is financially healthy. It means that a business makes some products/delivers services, pays all of its bills every month, as well as its taxes, and has money left over to do other things:
- pay out bonuses to employees
- invest in a new product line
- buy new equipment to manufacture that new product line
- Or if there are investors, pay them a dividend.
If you are looking for investors, having a positive free cash flow, and especially one that is going up over time, puts you in a good position. Most investors and financial institutions will definitely look at your balance sheets to check that number.
Why Free Cash Flow is Not The Ultimate Metric Though
That said, you should also understand that a continuously rising free cash flow is not the whole story of your financial health. It could mean that you have decided not to grow any bigger. That’s fine too, if your goal is to remain as you are. But the number will not accurately represent your business health in that case.
At the same time, as already mentioned above, a negative free cash flow is not always a bad thing. It takes money to grow, and there are times when you may decide to make a major push to expand. Or some of your clients paid you late this month and you are somewhat short on cash. In that case, you’ll probably want to adjust your payment terms for invoices.
Think of a negative cash flow situation in your personal life. You make a decision to go into debt to put an addition onto your home and remodel other parts of it. And you will be making payments on that debt for some time. And you have had to cut back on some other expenditures in order to make those payments. Things are tight for a few years. There is obviously no free cash flow in your household. On the other hand, you have added lots of value to your home, and you will get more than your money back when you sell it in a few years.
If a business has a continually low or declining free cash flow, and it has not used that cash for growth or expansion, then this should be a warning sign. Some things may have to change, if it intends to stay in business. Just treading water, or worse, sinking means a business is in serious trouble.
What is Considered a Good Free Cash Flow?
There is no definite answer to this question, for obvious reasons. And you should remember this: older, established businesses that have operated for a long time tend to have a positive cash flow consistently. Newer, younger companies, though, will often have almost a roller coaster of free cash flow, as they go through growth spurts. And they tend to pour lots of cash into growth in those early years, not seeing rising free cash flows at all.
As a small to mid-sized business owner, you always have decisions to make. And one of those decisions is how and when to choose to expand. Obviously, you need funds to accomplish those expansions, and keeping track of your free cash flow figures will be critical, as you think about your goals for growth. On one hand, you do not want to over-extend yourself; on the other hand, taking risks and going into negative free cash flow can result in longer-term growth that is well worth it.
While you can choose to use your free cash flow in any way you want, keep a balance. When times are good, it’s nice to reward your team for their hard work, and some of the free cash flow can do just that!
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