What Is Free Cash Flow and How Can You Calculate It?

Your Free Cash Flow Is an Indicator of Your Business' Health

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If you are running a business, it's important to understand what free cash flow is and how it differs from net cash flow. Your free cash flow is a key indicator of your business' health and profitability. It's essential that you can calculate it accurately to make key business decisions for your organization.

Free cash flow is how much money your business has leftover to use for other purposes after it has paid for capital expenditures, including buildings and equipment, and other expenses needed to sustain its ongoing operation.

Calculating free cash flow can be somewhat complicated, and there are actually several ways you can do it. If you use these methods correctly, though, all should generate the same answer (providing you with a good way to check your work).

Three Ways to Calculate Free Cash Flow

These three ways to calculate free cash flow (also sometimes known as "free cash flow to term") for your business are pretty easy to use:

1. Free Cash Flow = Sales Revenues - Operating Costs and Taxes - Required Investments in Operating Capital where:

In this equation, sales revenues are taken from the business income statement, as are operating costs and taxes. Investments in new operating capital show up as increases in fixed assets on the business balance sheet.

2. Free Cash Flow = Net Operating Profit After Taxes (NOPAT) - Net investment in operating capital

Here, NOPAT is the same figure [Sales Revenue - Operating Costs and Taxes] as in the first equation.

Net investment in operating capital is the same figure as the third term in the first calculation, or you also can use the increase in fixed assets on the balance sheet.

3. Free Cash Flow = Net Cash Flow From Operations - Capital Expenditures

Here, Net Cash Flow From Operations comes from the first section of the Statement of Cash Flows, and Capital Expenditures comes from the increase in fixed assets off the balance sheet.

As you'll realize when you examine these equations and work with them some, all three of these methods of calculating free cash flow should yield the same answer — they just approach the same information from different angles.

What Should You Do With This Information?

Companies that have a healthy free cash flow have enough funds on hand to meet their bills every month, plus some left over. A company with rising or high free cash flow generally is doing well and might want to consider expanding, whereas a company with falling or low free cash flow (or no money left over after covering the bills) may need to restructure.

It's not unusual, in fact, for investors to look for companies with rapidly rising free cash flow, since such companies may have excellent future prospects. If investors find a company with rising cash flow and an undervalued share price, that company may be an even better investment bet.

It's up to the business owners how to use free cash flow. The funds can be used to expand the business, pay dividends to shareholders, reduce debt or invest in research for new products.