Free Cash Flow Definition
Free cash flow is the amount of cash you have available—after you pay your operating and capital expenses—from the income your business produces from operations. You can calculate this number by using the free cash flow formula: Net Cash Flow From Operations – Capital Expenditures = Free Cash Flow. Having a good free cash flow number proves you have a healthy business which is likely to yield a nice return on investment.
You know how important cash flow is for your business. Without consistently positive cash flow, your business finances could run into serious trouble. This makes knowing how to calculate cash flow for your business—and how to use this calculation—vital to your success.
At its most basic, cash flow is the measure of cash moving in and out of your business over a period of time. But there’s more to calculating cash flow than subtracting your cash inflows from your cash outflows. If you’re looking to expand your business, attract investors, or even just create more financial security for your business, you need to know how to calculate a specific type of cash flow known as free cash flow.
What Is Free Cash Flow?
There are a number of ways to define and calculate free cash flow for your business. All of the methods for calculating free cash flow yield pretty much the same result, though. In this article, we’ll focus on the most common—and easiest to understand—free cash flow calculation and definition.
Simply put, free cash flow is the amount of cash you have available—after you pay your operating and capital expenses—from the income your business produces from operations. This is determined by a simple free cash flow calculation.
Free Cash Flow Formula
To calculate your business’s free cash flow, use the following formula:
Net Cash Flow From Operations – Capital Expenditures = Free Cash Flow
Let’s unpack this a little more.
The first part of this formula—net cash flow from operations—is the amount of cash that is left after you pay your business’s operating expenses. You can find this number on your profit and loss statement or your statement of cash flows. It’s important to remember that this net cash flow amount consists of the cash inflows and outflows only from your business’s operating activities. Some cash inflows and outflows will be excluded.
Most of your business’s cash probably enters into your business from sales. However, there are other methods by which cash can enter your business. A few of those methods are:
- Loans (either from you or a lender)
- Investments (either from you or an investor)
- Interest or dividends earned on investments your company has (like savings or money market accounts)
- Disposal of assets (as in the sale of equipment you no longer use)
Although all of these activities will increase your cash flow, and some of them will appear on your profit and loss statement, they are not included in the net cash flow from operations component of your free cash flow formula. Only cash inflows from operations—for most businesses, this is sales income—are included in the free cash flow calculation.
Similarly, not all cash outflows are included in the net cash flow from operations total, even if they appear on your profit and loss statement. Most of your business’s cash probably leaves the business in the form of operating expenses. Operating expenses include rent, utilities, payroll, office supplies, insurance—anything that goes into running your business. But cash also leaves your business in the form of:
- Loan payments
- Investment activity
- Draws and distributions
- Capital expenditures
The net cash flow from operations component of the free cash flow calculation only includes operating expenses. Capital expenditures also play a role in the calculation (more on that in a minute), but they are not included in net cash flow from operations.
Calculating Free Cash Flow
Regardless of the size and structure of your business, it’s relatively simple to calculate free cash flow. You’ll need your profit and loss statement and your balance sheet to obtain the various numbers needed for the free cash flow calculation. You can also use your statement of cash flows, but this isn’t strictly necessary.
Although you can calculate free cash flow for your business over any period of time, this calculation is typically most helpful if you look at one or more years’ worth of financial statements. This will help smooth any seasonal volatility in your business’s cash flow.
We recommend using your business’s financial statements instead of your bank statements for your free cash flow calculation. When properly compiled, your financial statements will give you a better summary of the numbers needed to calculate free cash flow for your business than your bank statements will.
Net Cash Flow From Operations
You will use either your profit and loss statement or your statement of cash flows to obtain the first figure for the free cash flow equation: net cash flow from operations. Again, this number does not include non-operating activity. So where do you look to find your net cash flow from operations?
From Your Profit and Loss Statement
Look for the “Net Operating Income” subtotal. This subtotal is located right beneath “Total Expenses,” as shown below:
Be careful before accepting this number at face value, though. If your chart of accounts is not configured correctly, non-operating income and expenses—like interest income, depreciation, or gain or loss on the disposal of assets—could be included in your “Net Operating Income” number. Talk with your bookkeeper if you have questions about the configuration of your business’s chart of accounts.
From Your Statement of Cash Flows
You can also get your net cash flow from operations number from your statement of cash flows report. Just like with your profit and loss statement, your chart of accounts must be configured correctly to give you the correct number.
Look for “Net cash provided by operating activities” on your statement of cash flows to find your net cash flow from operations number, shown below:
The capital expenditures number needed to complete the free cash flow formula comes from your business’s balance sheet. Specifically, you want to review your business’s increase in fixed assets from period to period.
Most accounting software packages will let you run a comparative balance sheet from one period to the next. In the following screenshot, we ran a comparative balance sheet from January 1, 2019, through April 28, 2020, and set a parameter to display columns by year. Then, we chose a setting that automatically calculated the dollar amount change for us.
For this particular business, capital expenditures total $13,495.00.
Free Cash Flow Calculation Example
Let’s say you own a sno-cone shack on a popular boardwalk. The following happens over the course of a year:
- Sales total $125,000.
- You pay your employees $25,000.
- Rent for your space on the boardwalk is another $25,000.
- You make a loan of $10,000 to your business to replace a machine that breaks just before the start of the season.
- The machine you replace costs $12,000.
- You also purchase a new air conditioner for your shack. It costs $3,000.
You will include all of the above except number four in your free cash flow calculation. Remember, free cash flow only includes cash flow from operations, and so you would not include the amount you loaned to your business in your calculation.
We’ll break down the free cash flow equation from above as follows:
Net Cash Flow From Operations = $125,000 (sales) – $25,000 (payroll) – $25,000 (rent)
Net Cash Flow From Operations = $75,000
Capital Expenditures = $12,000 (new machine) + $3,000 (air conditioner)
Capital Expenditures = $15,000
Net Cash Flow From Operations – Capital Expenditures = Free Cash Flow
$75,000 – $15,000 = Free Cash Flow
$60,000 = Free Cash Flow
Your sno-cone shack has $60,000 in free cash flow.
The Importance of Free Cash Flow
To continue our above example, $125,000 in sales from one sno-cone shack isn’t bad, but let’s say you think you could double that if you bought a second shack that just went up for sale on another boardwalk.
The owner of the other sno-cone shack needs cash fast and is asking $35,000 for their business and equipment. Because you know how to calculate your free cash flow, you know you have $60,000 available to invest in your business. This doesn’t mean you want to pay cash for the other sno-cone shack—in fact, doing so could deplete your cash reserves to the point of endangering your business—but your healthy free cash flow will work in your favor with a lender.
Investors are also very interested in a business’s free cash flow calculation. Having a good free cash flow number proves you have a healthy business which is likely to yield a nice return on investment.
But even if you don’t intend to bring on investors or expand your business, knowing your free cash flow will bring you peace of mind and help you ensure your business is in a position to weather downturns in sales. This makes knowing how to calculate free cash flow worth the effort.
The Bottom Line
Free cash flow is a metric that lets you measure the health of your business. As helpful as your free cash flow calculation is, though, it’s important not to put too much emphasis on it.
A low free cash flow calculation doesn’t mean your business is in trouble. Healthy businesses can see a decrease in free cash flow when they are in a growth cycle or as a part of the normal cycle of the business. For that reason, it’s important to understand what free cash flow is telling you in relation to your business’s profitability and other success metrics.
This is why it’s important to work with an accountant or financial coach who understands your industry and the various metrics most important to it. This professional should also understand your goals for your business and work with you in order to reach them.
In collaboration with your accountant or financial coach, you can learn to calculate free cash flow for your business and use it with other key performance indicators to help you grow a profitable business that serves you, regardless of where you are in your business journey.