Free cash flow is one of the key indicators used to show the health of the business, particularly its profitability. Typically, it demonstrates the amount of money any business for other purposes after all the capital expenditures that may include equipment, buildings and various other necessary expenses that help businesses sustain their operations.
Although calculating cash flow is a complicated process, there are many ways you can do it. According to experts, it is always better to use all methods correctly. If they all generate the same result, it provides you a reliable way to cross-check your operations.
It is worth noting here that cash flow doesn’t relate to all businesses. It is precisely a measuring tool that non-financial firms use rather than professional associations and investment firms. If you own a non-financial enterprise, you can calculate the cash flow for free with these three equations.
Equations to Calculate Free Cash Flow
1. Free Cash flow: Subtract operation taxes and costs from Sales revenues then subtract required investments for operation capital
The equation is one of the easiest ways to calculate free cash flow. Business owners take sales revenues, including taxes and operating costs from their income statement. The fixed assets show an increase when you invest in new operating capita. The balance sheet shows everything from investments and revenue details.
For example, if your business has earned revenues of $500,000, the amount is reduced to $300,000 because of taxes due and operating costs. If your business requires an investment of $150, 000, it will have the free cash flow of $30,000 to $50, 000.
2. Free Cash flow: Subtract net investments in operating capital from net operating profits NOPAT (after taxes)
NOPAT refers to the same figure we used in the previous equation: subtract operating taxes and costs from sales revenues. Net investment of operating capital uses the same figure that is used in the third term of first calculations. For calculating free cash flow through this equation, it is better to use the increased fixed assets on your balance sheet.
That means, your NOPAT will remain at the same amount of $30,000. You just need to exchange the required investment of your business in operating capital for your net investments in operating capital. If you assume the same figures, your free cash flow will remain the same.
3. Free Cash flow: Subtract capital expenditure from the net cash flow of operations
You can also calculate free cash flow by subtracting the capital expenditure from the net cash flow that comes from operations. Net cash flow in this equation comes from the cash flow statement, while capital expenditure is taken from the increase in the business’s fixed assets. For instance, if your operation’s net cash flow is around $200,000, the figure might be reduced by your capital expenditures.
Interestingly, all these free cash flow calculation methods will give you the same answers when you work with these equations. You might feel like approaching the same information and data from three different angles.
How does Free Cash Flow Calculation Affect Your Business?
As mentioned earlier, free cash flow is useful for the health of your business. Firms with healthy free cash flow are financially stable to meet the bills and investments every month. Plus, they also have leftover funds that they usually distribute among dividends and shareholders. Man firms use this extra fund to seize opportunities to help them generate more revenues through acquisitions of innovative products.
That is to say, if your business is booming and has high free cash flow, it is an indication that it is doing well and you should consider expanding it. Conversely, if it fails to generate good free cash flow, you might need to consider restructuring it as there are remaining funds after the basic expenses.
However, it is important to understand that poor free cash flow doesn’t always indicate a failing business. It might be expected even when your business is pursuing growth. Development and acquisition of new products are temporarily subtracted from the main capital. That is the reason why most of the investors tend to work with the businesses that have high free cash flow. These businesses are generally considered healthy with bright prospects. If an investor finds a business that has rising free cash flow with an undervalued share cost, it may be a great investment bet.
How can you Benefit from the Free Cash Flow
Since you understand how positive free cash flow may benefit you by indicating the healthy financial status of your business, it is better to use this understanding to your advantage. It is always better to look beyond the figures. Know that established firms have relatively consistent and healthy free cash flow. New businesses, on the other hand, are in a state where they need to pour money into growth and stabilization.
Although it depends on the business owners how they use the free cash flow, using the funds to expand the operations, pay shareholders and dividends, invest in new products, research or to reduce debt is beneficial for the business.
Always remember that companies that have surging free cash flow due to debt elimination, dividend distributions, cost reductions, efficiency improvements, or revenue growth can reward their investors in the future.
In other scenarios, when free cash flow is shrinking, businesses fail to sustain their growth earnings. Not only this, insufficient free cash flow for growth forces a business to boost debt levels. In a worse scenario, a business without enough free cash flow may not even have the liquidity to sustain.
Final Thoughts
All in all, it is important to find an all-purpose tool that can help you test the fundamentals of your business that seem elusive. Free cash flow calculation is like a performance metric they provide entrepreneurs an opportunity to guard up if their business is not generating enough revenues.
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