Free cash flow formula: Definition and calculation (a complete guide)

If you're running a business, knowing how to calculate and understand your free cash flow can be a game-changer. 

Forget the jargon for a second. Let's talk about what it actually means to have cash to play with after all the bills are paid and the necessary investments are made. It's that flexibility that allows you to grow, adapt, and maybe even take that well-deserved vacation.  

This guide will provide a clear process for calculating, interpreting, and ultimately improving free cash flow within the context of a business's operations.

What is free cash flow (FCF)?

Free cash flow is the money a business has left over after it has paid for all its necessary operating expenses and investments in assets. Simply put, it is the actual cash available for a business to use as it wishes. This can include paying dividends to owners, paying down debt, making new investments, or saving for future opportunities.

Think of it like your personal disposable income. After you get paid and cover all your essential bills, like rent, groceries, and utilities, plus any savings or investments you make, what you have left is your free cash. You can spend it on leisure, put it towards a vacation, or save it for a big purchase. Similarly, for a business, free cash flow is the money available after all essential expenses are paid.

It is important to distinguish free cash flow from profit. Profit is what remains after subtracting all expenses from revenue, and includes items that are not actual cash, such as depreciation. This metric focuses specifically on the cash that flows in and out of the business. It provides a much clearer picture of the actual cash situation of a business, making it a critical metric for understanding financial health and strategic decision-making.

Why is calculating free cash flow important?

A healthy free cash flow figure highlights that the company's financial health is currently on strong ground and highlights the potential for future growth and business expansion. Furthermore, free cash flows will be analyzed by investors and other relevant parties when determining the value of the company.

In addition to highlighting cash inflows and sales revenue, the free cash flow figure takes capital expenditure into account. By subtracting current liabilities from the cash generated figure, businesses can produce an accurate financial statement that identifies current performance levels.

Generally, free cash flow is calculated on an annual basis via an annual cash flow statement. However, it can also be calculated on a quarterly or monthly basis. There are several reasons you might choose to calculate free cash flow on a quarterly or monthly basis, including:

Better track changes in free cash flow over the short term

Tracking changes over a specific period can provide helpful information about whether a business is growing or shrinking. It gives you a far better understanding of your ongoing operating capital and non-cash working capital (operating capital that isn't liquid cash) demands.

Compare the current quarter or month to previous ones

This can help identify potential areas of concern, such as declines in revenue or increased capital spending. It is one way how free cash flow can highlight the need to generate cash or alter your operating activities

Provide a more realistic view of cash flow 

Some businesses may experience significant one-time expenses that may not represent their actual cash flow over an extended period.

More accurate financial predictions

Comparing free cash flow to actual spending and income allows you to forecast future performance better. This can be used to plan for future investments or budgeting decisions by considering the long-term implications.

Better understand customer spending trends

By looking at the year-over-year revenue changes, you can better understand how customers are responding to your offerings, helping you make better decisions about product development and marketing efforts. In turn, this can help boost sales revenue to create a rising cash flow.

Assess how well-capitalized a business is relative to its size and the company's industry

If a company has a solid free cash flow close to its balance sheet, this can indicate that it is well-positioned to handle any financial issues that may arise.

Why frequent free cash flow tracking matters

There are numerous reasons to assess financial performance, and the benefits of doing so are far-reaching. When a company pays attention to its free cash flow on a more frequent basis, it will promote accurate accounting and help you make better short-term decisions while simultaneously providing valuable insights to shape future decisions as you expand operations or take on more employees.

Whether evaluating a potential investment or making decisions about operations, understanding financial performance is crucial to success. Reviewing your company's financial data will provide invaluable knowledge that can be used to create a strong foundation for long-term growth.

What is the free cash flow formula?

Accounting software can be used to calculate free cash flow with ease. However, knowing how to calculate free cash flow and prepare a cash flow statement is a hugely beneficial skill for business owners.

The free cash flow formula calculates the amount of cash a company has available for activities unrelated to its core operations.

The formula is calculated by subtracting capital expenditures from operating cash flow and adding non-cash items, such as depreciation and amortization.

To work out your free cash flow, you'll first need to work out your operating cash flow. Your operational flow is the money that comes into your business through sales and other activities minus any operational expenses.

The formula for operating cash flow is generally expressed as follows:

There are several other terms, such as 'net income', that you'll need to understand how to calculate to work out your free cash flow, so let's look at them.

Net income

This is the amount a company earns after subtracting all its expenses, including taxes and other charges. It's also known as net profits or the 'bottom line'. To work out this figure, you must take your total revenue and subtract all of your company's expenses for the period.

Non-cash items

Non-cash items include depreciation and amortization, which are costs associated with assets such as buildings and equipment spread out over several years. If the asset is used for core business activities, they are classed as an operating expense.

Changes in working capital

Changes in working capital refer to the difference between a company's current assets (cash, accounts receivable, inventory) and its current liabilities (accounts payable).

A positive change in working capital indicates that more cash was used to pay down debt or purchase new assets, while a negative working capital suggests that a company has spent more money than it received in cash.

Using operating cash flow (OCF) to work out free cash flow

Once you know your operational cash flow, you can use this number to work out the free cash flow.

Free cash flow is calculated by subtracting capital expenditures (such as investments in new equipment or buildings) from operating cash flow.

Before making the calculation, it is important to calculate the net investment figure - which is the total capital expenditure on current assets minus the cost of depreciation.

To calculate free cash flow, you must use the following formula:

Once calculated, the free cash flow formula indicates how much money a company has available after it pays for its operations and investments. It's an essential indicator of a business's financial health, as free cash flow can be used to invest in growth initiatives, pay down debt, or return money to shareholders through dividends.

Meanwhile, consistent free cash flow growth over several months or years highlights the company's stability.

Where to find free cash flow (or how to approximate it from accounting software)

For business, understanding free cash flow doesn't require complex financial acrobatics. Your existing accounting software likely holds the keys, either directly through a cash flow statement or indirectly through your income statement and balance sheet.

• Cash flow statement: This statement provides a clear view of the cash generated and used by your business over a period. Look for the "Net cash from operating activities" section, which represents your operating cash flow (OCF). This is a crucial starting point for calculating free cash flow.
• Income statement and balance sheet: If your software doesn't generate a full cash flow statement, you can approximate OCF by starting with your net income (from the income statement) and then adjusting for non-cash items like depreciation and changes in working capital accounts, including accounts receivable.
  

How accounts receivable (AR) impact operating cash flow

Accounts receivable, the money owed to your business by customers for goods or services already delivered, has a direct impact on your operating cash flow.

• Faster collections = Higher OCF: When you collect payments from your customers quickly, that cash flows into your business, increasing your operating cash flow. Think of it like getting paid promptly for a job well done – you have that money available sooner.
• Late payments tie up cash and reduce OCF: Conversely, when customers pay late, that cash remains tied up in your accounts receivable. This means you don't have that money readily available to cover your own expenses or invest in growth, effectively reducing your operating cash flow. It's like waiting for a client to pay their invoice before you can pay your own bills.

How AR automation helps improve OCF

Managing accounts receivable manually can be time-consuming and prone to errors, often leading to delayed payments. AR automation software can significantly improve your operating cash flow by:

• Automating invoice sending and reminders, ensuring customers receive invoices promptly and are reminded of upcoming or overdue payments.
• Streamlining the payment process, making it easier for customers to pay on time through various digital payment options.
• Providing better visibility into outstanding invoices and potential payment issues, allowing you to proactively address them.

By reducing the time it takes to collect payments, AR automation helps businesses unlock cash faster, leading to a healthier operating cash flow and ultimately, a stronger free cash flow position. This readily available cash can then be used for essential business needs and growth opportunities that business owners understand and value.

How to calculate free cash flow

To truly grasp the concept of free cash flow, let's delve into a straightforward and easily understandable illustration: Sarah's Bakery. By following the journey of Sarah's business finances, we can clearly see how the metric is calculated and, more importantly, why it's a crucial metric for assessing a company's financial health and flexibility.

Step 1: Pinpointing Operating Cash Flow – The Engine of the Business

The first critical step in determining free cash flow is to understand the cash generated from the core operations of the business, known as operating cash flow. This figure represents the cash inflow resulting directly from the day-to-day activities of Sarah's Bakery, such as selling pastries, cakes, and other baked goods. It reflects the cash that the bakery brings in from its primary revenue-generating activities, adjusted for any operational expenses and changes in working capital accounts.

In our example, Sarah's Bakery demonstrated a robust ability to generate cash from its operations, amounting to $50,000 USD over the past year. This $50,000 USD represents the net cash inflow that Sarah's Bakery received from its regular business activities.

This positive OCF indicates that Sarah's fundamental business model is sound and capable of producing more cash than it consumes through its daily operations. It's the lifeblood of the company, providing the resources needed to cover ongoing expenses and invest in future growth.

Step 2: Identifying Capital Expenditures – Investing in the Future

The next essential component in calculating free cash flow is identifying the capital expenditures incurred by the business. Capital expenditures are investments made by a company in long-term assets that are expected to provide benefits for more than one year. 

These investments are crucial for maintaining and expanding the operational capacity and efficiency of the business. Examples of CapEx for a bakery might include the purchase of new ovens, mixers, refrigerators, or even an expansion of the bakery premises.

In the case of Sarah's Bakery, to meet increasing customer demand and enhance its production capabilities, Sarah decided to invest in a new oven costing $10,000 USD. This purchase is classified as a capital expenditure because it's a significant investment in a long-term asset that will contribute to the bakery's production for years to come.

It's important to note that CapEx does not include routine maintenance or repairs, which are typically considered operating expenses. Capital expenditures are about acquiring or significantly improving long-term assets.

Step 3: Calculating Free Cash Flow – The Available Residual Cash

With both the operating cash flow and capital expenditures identified, we can now proceed to calculate the free cash flow using the fundamental free cash flow formula:

This formula essentially subtracts the cash spent on maintaining and expanding the company's asset base (CapEx) from the cash generated by its core operations (OCF). The resulting figure, the free cash flow, represents the cash flow available to the company after accounting for these essential business investments. This is the cash that the company has the discretion to use for various purposes that can enhance shareholder value.

Applying this formula to Sarah's Bakery:

This calculation reveals that Sarah's Bakery has a free cash flow of $40,000 USD.

Interpreting Sarah's Bakery's free cash flow

The free cash flow of $40,000 USD for Sarah's Bakery is a significant indicator of the company's financial strength and flexibility. It signifies that after covering all the cash expenses related to its daily operations and investing in a crucial capital asset (the new oven), Sarah's Bakery still has $40,000 USD of cash available.

Using net income to work out free cash flow

An alternative method to calculate free cash flow involves starting with net income rather than operating cash flow. This approach is more commonly seen in detailed financial analysis and offers a different perspective on cash flow generation. While it might seem more complex, understanding this method can provide deeper insights into your business's financial health.

This formula looks like this:

Understanding the components of the alternative free cash flow calculation

Net income: Profit after all expenses, including taxes

Net income is essentially the profit that remains after all business expenses, including taxes, have been deducted from the revenue. It’s the bottom line on your income statement and reflects the company’s profitability for a specific period.

Depreciation & amortization: Add back these non-cash expenses

Depreciation and amortization are accounting methods used to allocate the cost of assets over their useful lives. These are non-cash expenses, meaning they don't involve an actual outflow of cash. Since we're focusing on cash flow, these amounts are added back to net income. Think of it as adding back costs that were accounted for, but didn't involve cash leaving the business.

Change in working capital

Working capital is the difference between a company’s current assets and its current liabilities.

For businesses, key components to consider are:

• Increase in accounts receivable (AR): When AR increases, it means more customers owe you money, but haven't paid yet. This ties up cash, so it's subtracted in the free cash flow calculation.
• Increase in inventory: An increase in inventory means you've purchased more goods, which uses cash. This is also subtracted.
• Increase in accounts payable (AP): When AP increases, it means you owe more money to your suppliers, but haven't paid them yet. This effectively retains cash in your business, so it’s added back.

Reducing accounts receivable directly improves this component. If you collect payments from customers faster, you decrease AR, which means less cash is tied up. This reduction positively impacts the change in working capital, increasing your free cash flow.

In essence, while starting with net income requires a few adjustments, it ultimately leads to a similar understanding of how much cash your business generates and has available after essential expenses and investments.

How to interpret free cash flow 

Free cash flow is a vital metric, but interpreting it correctly is key to understanding the financial health of your business. Here's how to make sense of yours.

Positive free cash flow

Generally, a good sign, a positive number indicates that a business generates more cash than it needs for operations and investments.

• What to do with it: With extra cash, you can reinvest in the business for further growth, pay down debt to reduce interest expenses, save for future opportunities or emergencies, or distribute profits to owners.
• Caveat: It's crucial to determine if the positive free cash flow is due to one-off events, like selling an asset, or sustainable operations. If the metric is sustainable and positive, derived from strong sales and efficient operations, it is a much stronger indicator of financial health.

Negative free cash flow

Negative free cash flow is not always bad, especially for growth-stage businesses that are investing heavily in expansion, equipment, or technology.

• Potential red flags: However, a negative metric can also signal problems. Is the business spending too much on expenses? Are sales declining, leading to less cash inflow? Are collections poor, resulting in high accounts receivable?
• When to be concerned: Be particularly concerned about persistent negative free cash flow without a clear investment strategy. If a business consistently spends more than it generates without a plan for future profitability, it may face financial difficulties.

Free cash flow trends

Trends over time are more important than a single period's number. Look at whether the metric is growing, stable, or declining over several periods. 

Understanding the reasons behind these trends is critical. Growing free cash flow suggests improved efficiency or sales growth. A decline might indicate operational issues, increased expenses, or investment in long-term assets.

Benchmarking

Comparing your free cash flow to industry benchmarks or your own historical performance can provide valuable context. If possible, see how it stacks up against similar businesses in your industry. Alternatively, comparing your metric this year to previous years can highlight improvements or areas that need attention.

How to improve free cash flow

Improving free cash flow is crucial for the financial health and growth of your business. Here are some strategies to enhance it:

Improve operating cash flow

Operating cash flow (OCF) is the foundation of free cash flow. Increasing OCF directly boosts your free cash flow.

Here are several methods to improve it:

Accelerate accounts receivable collections

Collecting payments faster improves your cash flow. Here's how:

• Invoice promptly and accurately: Send invoices immediately after providing goods or services to avoid delays. Ensure accuracy to prevent disputes and payment holds.
• Offer multiple payment options: Provide various payment methods (credit card, online transfer, etc.) to make it easy for customers to pay quickly.
• Implement clear payment terms: Clearly state payment due dates on invoices to set expectations and avoid confusion.
• Proactive payment reminders & follow-ups: Send timely reminders for upcoming payments and follow up on overdue invoices promptly.

Streamline AR with automation (like Chaser)

AR automation software such as Chaser can significantly streamline your accounts receivable process. These tools automate invoice sending, payment reminders, and follow-ups, reducing manual work and errors. By ensuring invoices are sent promptly and customers are reminded effectively, AR automation reduces late payments and directly increases your operating cash flow.

Manage inventory efficiently

Avoid overstocking: Holding excess inventory ties up cash. Maintain optimal inventory levels to meet demand without overstocking.

Optimize pricing strategy

Ensure margins are healthy: Review your pricing regularly to ensure your margins are sufficient. Adjust prices as needed to maintain profitability without losing customers.

Control operating expenses

Regularly review and reduce unnecessary costs: Scrutinize all operating expenses to identify areas where costs can be cut without affecting operations.

Manage capital expenditures wisely

Capital expenditures (CapEx) are significant investments that affect free cash flow. Manage them effectively:

• Prioritize essential investments: Before making large capital expenditures, prioritize investments that are essential for operations and growth.
• Consider leasing vs. buying for some assets: For some assets, leasing might be more cost-effective than buying outright, reducing upfront costs.
• Phase large expenditures if possible: If possible, phase large expenditures over time to manage cash flow better.

Optimize working capital

Effective working capital management can significantly improve your free cash flow:

• Negotiate better payment terms with suppliers: Negotiate longer payment terms with suppliers where appropriate, without damaging relationships to hold onto cash longer.
• Improve inventory turnover: Enhance inventory turnover by improving sales strategies and reducing slow-moving stock, thereby freeing up cash.
• Emphasize efficient AR: As mentioned earlier, efficient accounts receivable (AR) management is critical. Ensure faster collection of payments from customers.

Common mistakes businesses make with free cash flow

Small and medium-sized businesses often encounter challenges when it comes to managing free cash flow. Here are some common mistakes and how to avoid them.

Ignoring it altogether

Many businesses focus primarily on revenue and profit, overlooking the significance of free cash flow. This can lead to situations where a business is profitable on paper but lacks the cash needed for daily operations or growth opportunities. Failing to track FCF can result in unexpected cash shortages and limit the business's ability to seize opportunities.

Confusing free cash flow with profit

It's crucial to distinguish this metric from profit. Profit is what remains after subtracting all expenses from revenue, including non-cash items like depreciation. Free cash flow, on the other hand, represents the actual cash available after covering all expenses and investments. Confusing the two can lead to an inaccurate understanding of the business's financial health.

Not tracking CapEx properly

Capital expenditures, such as investments in new equipment or buildings, significantly impact free cash flow. Many businesses fail to track CapEx accurately, which can distort the calculation. Underestimating or overlooking these investments can result in an inflated free cash flow figure, leading to poor financial decisions.

Failing to understand the impact of working capital changes (especially AR)

Changes in working capital, particularly accounts receivable, can have a substantial effect on free cash flow. A rise in AR means more customers owe money, but haven't paid yet, tying up cash. Many businesses underestimate the impact of delayed payments and poor collection practices. Failing to manage AR effectively can significantly reduce operating cash flow and, consequently, your free cash flow.

Making big decisions without considering free cash flow implications

Major business decisions, such as expanding operations, launching new products, or taking on debt, should always consider the impact on free cash flow. Many businesses make these decisions based solely on revenue projections or profit expectations, without assessing the cash flow consequences. This can lead to overextension and financial strain if the business doesn't generate sufficient cash to support these initiatives.

How Chaser can help

Chaser is AR automation software that significantly improves free cash flow for businesses by accelerating payment collection. It automates invoice sending and follow-ups, reducing delays and boosting operating cash flow.

Chaser lowers Days Sales Outstanding (DSO) through systematic reminders and better visibility into overdue accounts. By optimizing collections, it enhances operating cash flow, a key driver of free cash flow. 

Real-time dashboards and reports provide insights for data-driven decisions and better cash flow forecasting. Chaser streamlines payments with digital options, encouraging prompt payments. Ultimately, these features enhance financial stability by ensuring consistent cash inflows, reducing reliance on external financing, and increasing your free cash flow for growth and strategic initiatives.

Wrapping it up

Free Cash Flow (FCF) is crucial for businesses as it represents the cash available for growth, debt repayment, savings, and owner distributions after covering all operational expenses and investments. 

Understanding and managing it provides businesses with the financial flexibility to adapt, invest, and ensure long-term stability. It empowers owners to make informed financial decisions and secure their business's future.

It is highly recommended for business owners to start calculating and tracking their free cash flow regularly. Doing so provides a clear picture of their financial health and enables proactive management of their cash resources. Try Chaser auto-call free for 10 days to streamline accounts receivable and improve your free cash flow.

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