What Is Free Cash Flow and How Can You Calculate It?
Free cash flow is an indicator of overall business health
Your free cash flow is a key indicator of your business's health and its profitability. It's how much money your business has left over to use for other purposes after it's paid for capital expenditures such as buildings, equipment and other expenses necessary to sustain its ongoing operation.
It's essential that you calculate your free cash flow accurately so you can make key business decisions. The calculation process can be somewhat complicated and there are actually several ways to do it. But if you use these methods correctly, they should all should generate the same answer—providing you with a good way to double 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," are among the easiest to use.
Free Cash Flow = Sales Revenues - Operating Costs and Taxes - Required Investments in Operating Capital
In this equation, sales revenues are taken from the business's 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.
If Joe's Business has sales revenues of $500,000, this figure might be reduced to $200,000 by $300,000 in operating costs and taxes due. If the business's required investments were $150,000, Joe would have free cash flow of $50,000.
Free Cash Flow = Net Operating Profit After Taxes (NOPAT) - Net investment in Operating Capital
Here, NOPAT is the same figure used in the first equation: sales revenue - operating costs and taxes. Net investment in operating capital is the same figure as the third term in the first calculation. You can also can use the increase in fixed assets on the balance sheet.
Joe's NOPAT remains at $300,000. We're simply exchanging his required investments in operating capital for his net investment in operating capital. Assuming they're the same, his free cash flow would remain much the same.
Free Cash Flow = Net Cash Flow From Operations - Capital Expenditures
Net cash flow from operations comes from the first section of the statement of cash flows in this equation while capital expenditures comes from the increase in fixed assets off the balance sheet. If Joe's net cash flow from operations is 200,000, this would be reduced by his capital expenditures.
When you examine these equations and work with them some, you'll realize that all three methods of calculating free cash flow should yield pretty much the same answer. They just approach the same information from different angles.
The Effect of Free Cash Flow
Positive free cash flow is indicative of overall business health. Companies that have a healthy free cash flow have enough funds on hand to meet their bills every month plus some left over. The excess might be distributed among shareholders as dividends or it might be used to seize upon opportunities to generate more income through acquisitions or new, innovative products.
A company with rising or high free cash flow is generally doing well and might want to consider expanding, whereas a company with falling or low free cash flow might need to restructure because there's no money left over after covering the bills.
Low free cash flow is not always indicative of a failing business, however. It can be expected at times when even a healthy company is actively pursuing growth. Those acquisitions and new, innovative products will temporarily subtract from the bottom line.
That said, it's not unusual for investors to look for companies with rapidly rising free cash flow because such companies tend to have excellent future prospects. If investors find a company with rising cash flow and an undervalued share price, it can be an even better investment bet.
What Should You Do With This Information?
Try to look beyond the numbers. Keep in mind that older, more established companies tend to have more consistent free cash flow while new businesses are typically in a position where they're pouring money into stabilization and growth.
Free cash flow does not relate to the health of all businesses. It's mostly a measuring tool for non-financial enterprises rather than investment firms and professional associations.
It's up to business owners how they want to use their free cash flow. The funds can be used to expand the business, to pay dividends to shareholders, to reduce debt, or to invest in research for new products or other means of expansion.