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Understanding business profitability with free cash flow

by Samuel Williamson

2 min read

Free cash flow is the remaining cash after a business pays for capital expenditures such as property, plant or equipment (PP&E). This cash can be used for paying dividends to investors, expanding the business, developing new products or covering other financial obligations.

Free cash flow is a useful measure for understanding a business’s true financial performance. For investors, it can tell a much better story than more commonly used profitability metrics like net income or earnings per share, and it’s harder to manipulate.

Cash flow versus free cash flow

Free cash flow is not the same as cash flow. Cash flows are inflows and outflows of cash and cash equivalents. In a cash flow statement, operating cash flow is the amount of cash a business has generated from its operations over the period. This is often different from profit or net income, which includes sales or purchases made on credit, and thus not physically paid for at the end of the period.

Free cash flow is calculated from operating cash flow, less capital expenditure for the period. The figures for operating cash flow and capital expenditure are easily collated from cash flow and income statements within your accounting software.

For example, if a business has purchased equipment during the year totalling $75,000, and has an operating cash flow of $100,000, their free cash flow is $25,000.

A business health check

Because free cash flow is a measure of a business’s ability to generate cash, a positive free cash flow figure means the business has cash to reduce debt, expand or pay out dividends. If free cash flow figures are increasing over time, this is a great sign for investors, showing positive business health. If free cash flow is declining, it could signal trouble ahead.

On the other hand, a negative free cash flow figure requires greater scrutiny. Is the figure negative because the company isn’t profitable? Or if it is profitable, is the business struggling with its customers not paying on time? Alternatively, is the business able to generate positive operating cash flows, but has invested heavily in capital expenditure? Negative free cash flow is not always a bad thing in itself, particularly when it is due to the business making investments.

Considerations

Because the figure for free cash flow is derived from operating cash flow, which is in turn derived from net income, it’s important to bear in mind that any gain or loss that is not part of the core business can affect free cash flow.

For instance, if a company makes a one-off gain from an asset sold, this will present positively in a free cash flow analysis, boosting the figure in a way that makes the company’s ability to generate cash appear stronger than it is.

A company could also influence its free cash flow by prolonging payment to suppliers, which preserves the cash held in the business, or by shortening its customers’ normal payment terms towards the end of an accounting period.

Regardless, free cash flow remains an important metric for investors. The more free cash flow a company has, the easier it can pay its creditors and investors, or reinvest.

Read more about preparing your cash flow statement here.

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