Last Updated on March 9, 2022
When you’re running a business, there are many things to keep records of. There are expenses, taxes, and payroll, to name a few. One essential thing to track is your free cash flow, or FCF. It may seem daunting, but this article will detail what free cash flow is and how to calculate it.
What is Free Cash Flow?
In the simplest terms, free cash flow is the available money left over after you’ve paid all the bills. It’s the amount remaining after you’ve paid things like payroll, taxes, rent, and operations expenses. It sounds very similar to profit but isn’t quite the same. The critical difference is in the word “free.” Free cash flow doesn’t account for things like stocks, assets, or money that has not been paid to you yet.
Another way to think about it is like this: after you calculate what remains after expenses, could you go to the bank and get that amount in cash? If the answer is no because that money is tied up in something like investments, that doesn’t count toward your free cash flow.
How to Calculate Free Cash Flow
The equation for calculating cash flow is a relatively simple one, especially if you have an income statement or balance sheet. If not, you’ll need to calculate some information. There are a few numbers you need.
Your net income is the total amount of money your company has earned subtracted by your expenses, which looks like this: net income = total amount earned – expenses.
For example, an employee earns a specific salary, but that isn’t the amount they get paid. They have things like taxes and insurance taken out of their check. Their net pay is the amount of money deposited into their account or written on their check. It works the same way for businesses.
For example, Sally has started a business making jewelry and selling it online. Her expenses include the materials, shipping costs, and fees paid to Etsy. In one month, those things add up to $200. In that month, the sales she made from that jewelry totaled $350. Sally has a total of $150 in net earnings because $350-$200=$150.
Depreciation and Amortization
Depending on the type of business, this may or may not be something you need to calculate. Depreciation is the loss of value of an asset. To calculate depreciation, start with the initial cost of an asset.
Estimate the salvage value or the amount you think the asset will be worth when you’re done using it. The salvage value is essentially the resale value. Subtract the salvage value from the initial cost, then divide by the number of years you expect to use the item. That will be the annual depreciation cost.
Here’s the formula: depreciation = (asset cost – asset resale value) / expected number of years of use.
If you want to break it down into months or quarters, you can continue to divide.
For example, Joe has started a computer repair business, but he needed to purchase a car to make house calls. He paid $10,000 for his car. He plans to use it for about ten years and is guessing he could probably sell it for $2,000 at that time.
$10,000-$2,000=$8,000, making the total estimated depreciation $8,000. $8,000/10=$800, giving him a total annual depreciation of $800. However, Joe prefers to use financial quarters. $800/4=$200, meaning the quarterly depreciation of his truck is $200.
Amortization is similar to depreciation. The difference is that depreciation refers to a tangible asset, while amortization is an intangible asset, such as a loan, trademark, or patent.
Changes in Working Capital
Working capital is your total current assets subtracted by your total current liabilities. Examples of assets may include money, whether in cash or an account, short-term investments, money owed to you, and inventory. Liabilities are things like loans, wages, or taxes that you need to pay.
The formula looks like this: change in working capital = (total current assets – total current liabilities) – (previous period’s total assets – previous period’s total liabilities).
For example, Marissa has a photography business. Her assets include $2,000 in her business account, $4,000 worth of equipment, and she is expecting $1,000 in the next few days when she finishes editing her client’s wedding photos. That puts her total assets at $7,000. However, to buy her equipment and start up her business, she took out a small business loan which she is paying off at $250 per month.
When Marissa checked her records, she discovered that last month her assets were at $6000, but her liabilities were the same. That means her change in working capital from last month to this month is $1000.
Capital expenditure is money used by your company to benefit your company. They cover things like equipment, buildings, vehicles, and software.
Basically, capital expenditure equals the total spent to improve or grow your company.
For example, Daniel has a woodworking and carpentry business. For the month, some of his costs include $400 in website hosting fees and online advertisements, $500 to build a new woodshop, and $300 in equipment. Those costs give him a total of $1,200 in capital expenditure.
The Equation for Free Cash Flow
Now that you have all your numbers, you can determine your free cash flow with this equation: net income + depreciation / amortization – change in working capital – capital expenditure.
For example, if your net income for the last month was $5000, your depreciation was $100, your change in working capital was an increase of $200, and your capital expenditure was $300, your equation would look like this: $5000+$100-$200-$300=$4,600.
Benefits and Limitations of Free Cash Flow Calculation
Investors often use free cash flow calculations to determine a company’s growth or potential for growth. However, it’s not always a good indicator of the health of a company. Many companies will have a lower cash flow or even a negative cash flow for the first few years as they work to build themselves up.
Your free cash flow may be low or negative as you invest in your company, but you may be using those investments to put your company in a better position and have more free cash flow in the future. Additionally, some industries measure success by different metrics, and free cash flow may not be relevant.
Free Cash Flow vs. Net Cash Flow
Another reason that free cash flow isn’t always the best way to calculate the health of a business is because it doesn’t include things like financial investments. Net cash flow, on the other hand, does. It encompasses much more and gives a more broad look at how things look overall.
Jim is the General Manager of altLINE by The Southern Bank. altLINE partners with lenders nationwide to provide invoice factoring and accounts receivable financing to their small and medium-sized business customers. altLINE is a direct bank lender and a division of The Southern Bank Company, a community bank originally founded in 1936.