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Understanding business profitability with free cash flow

February 26, 20207 min read

Most working businesses have a constant stream of income and expenditures stemming from a variety of different operating activities. So, working out how much cash your business has available to spend can be confusing. But, that’s no excuse for poor financial planning.

To make sure you’re investing correctly in your business, have enough left over to satisfy the ATO, and are generating enough profit to satisfy your investors, you need to take control of your business’s spending and work out how much working capital you have at your disposal. You need to calculate your free cash flow.

Learn how you can calculate free cash flow and why it’s an essential business metric below.

What is free cash flow?

Free cash flow is operating cash flow minus capital expenditures. It’s the remaining cash after a business pays for capital expenditures such as property, plant, or equipment (PP&E). This cash can be used to pay dividends to investors, expand the business, develop new products, or cover other financial obligations.

Free cash flow is a useful measure for understanding the firm’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.

What is the free-cash-flow formula?

There are a few different ways to calculate your business’s free cash flow. However, the most complete formula is:

Net income + interest expense – tax shield on interest expense + non-cash expenses – (change in current assets – change in current liabilities) – capital expenditures (CAPEX) = free cash flow

If you have a keen eye for detail, you’ll recognise them from your financial statements or balance sheets. Here’s a look at each element of the equation.

Must-know free-cash-flow terms

If you don’t understand what the terms of the free cash flow formula mean, you’ll struggle to put them into practice. Here are the elements you need to plug into your free cash flow equation.

Net income

Net income refers to your company’s earnings after all other expenses have been deducted.

For example, if your business sold $500,000 worth of stock last year but you spent $100,000 on salaries, paid $100,000 in tax, and bought $75,000 in new stock, your net income would be $225,000.

Obviously, salaries, tax, and materials aren’t the only expenses that can eat into a business’s net income, but they will usually account for a very large percentage of your expenses.

Interest expense

This refers to the amount of interest that you pay on any outstanding borrowings. If your company went to the bank and received a loan of $200,000 at an interest rate of 5%, then your interest expense would be $10,000 (200,000 x 0.05).

This interest expense figure will also appear at the bottom of your income statements.

Tax shield on interest expense

A tax shield refers to anything that will reduce a person or business’s tax bill. In other words, something that’s tax-deductible and can therefore be used to offset your taxable income.

Interest expenses fall under this bracket. An interest expense lowers the total income that a business has, which therefore reduces its tax bill.

Non-cash expenses

The most common non-cash expense is depreciation, but amortisation (paying off debts with a number of regular payments), stock-based compensation (paying those who have shares in the business), and unrealised gains or losses (when an asset becomes more or less valuable on paper but has yet to be sold) are other examples of non-cash expenses.

Failing to include non-cash expenses could have a significant impact on a company’s free cash flow analysis.

Change in current assets – change in current liabilities

Current assets are anything that brings money into your firm (cash and accounts receivable), whereas current liabilities refers to money leaving your firm (such as accounts payable and taxes payable).

The change in these figures indicates whether or not your business is receiving more than it’s spending or vice-versa. This amount left over is referred to as your business’s net working capital.

Capital expenditure (CAPEX)

Capital expenditure is the money spent by a company on the acquisition, maintenance, or reinvestment of assets, such as land, buildings, or equipment. CAPEX is usually high for businesses that are just starting out.

Operating cash flow vs. free cash flow

Free cash flow is not the same as operating cash flow . For example, in a yearly cash flow statement, also referred to as a statement of cash flows, operating cash flow is the amount of cash a business has generated from its operations over the period. Businesses need sufficient cash flow to stay afloat.

On the other hand, free cash flow is calculated from operating cash flow minus capital expenditure for the period. Free cash flow is, therefore, a much better overall indicator of your business’s financial health. After all, there’s little point in celebrating that you’ve brought in $100,000 from your operations if you’re forgetting that you’ve already spent $50,000 on new machinery.

The figures needed to calculate your business’s operating cash flow and capital expenditure can be found on your cash flow and income statements in your accounting software.

The ideal business health check

Free cash flow is a key metric, indicating how well a company is doing. This figure can be used to woo investors, apply for loans from the bank, and help dictate key business decisions going forward.

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 the funds available to reduce debt, expand operations, or pay out dividends to shareholders.

If free cash flow figures are increasing over time, this is a great sign for investors because it shows good business health. Of course, many businesses will struggle to generate a positive free cash flow for the first few years of operations — plenty of money will need to be spent on expanding operations, testing out new products, and building the brand.

In an ideal world, the business’s free cash flow figures would start to creep up once the company is off the ground. However, if free cash flow continues to decline and regular operating expenses are consistently too high, this could signal real trouble.

But, it’s not as simple as saying that a negative free cash flow is bad. It’s obviously not great, but it demands scrutiny in order to work out exactly what the problem is.

For example, the figure might be negative because the company isn’t profitable. Or, it could be a profitable business that’s struggling to get its customers to pay in a timely manner. Or, the business might be generating positive operating cash flow but also be investing heavily in capital expenditure, leading to low free cash flow.

Negative free cash flow isn’t always a bad thing in itself, particularly when it’s due to the business making forward-thinking investments. As the old adage goes, ‘You have to spend money to make money.’

Free cash flow isn’t the final answer

Because the figure for free cash flow is derived from operating cash flow, which is in turn derived from net income, any gain or loss that’s 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 (such as one of its unused office spaces), 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.

Unless the company in question is in the property industry, it’s unlikely that it’s going to regularly sell its buildings. Therefore, this one-off gain is just that — a one-time occurrence.

There are a few other ways that a company can influence its free cash flow. It could prolong its payment to suppliers, which preserves the cash held in the business, or shorten its customers’ normal payment terms towards the end of an accounting period.

This means that while it’s not as easily manipulated as some other metrics, there are ways in which a company can skew the results in their favour.

Use free cash flow to make smart business decisions

Although free cash flow isn’t perfect, it remains an important metric for investors and a good indicator of a company’s business operations. The more free cash flow a company has, the more easily it can pay its creditors and investors, or reinvest. Simple as that.

So, go out and use the free cash flow figure to make spending decisions with confidence. Whether you’re a corporate finance student, investor, or budding entrepreneur, free cash flow can give you an inside look at a company’s financials.

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