Free Cash Flow Formula
As a small business owner, it’s easy to get caught up in the amount you’ve invoiced.
The amount you invoice doesn’t tell the full picture. It doesn’t reveal the money spent on software subscriptions, conferences, payment processing fees, and hiring independent contractors.
This is where small business accounting comes in. There are different metrics and formulas you can use to give you a more accurate insight into your business’s actual profitability, both now and in the future.
So today, we’re talking about free cash flow: the definition, why it’s important, and how to calculate it.
Let’s dive in.
What is free cash flow?
Free cash flow (FCF) is the difference between cash generated from standard business operations and cash spent on assets. It indicates your business’s financial performance and health, and ability to stay in business. In accounting, we call this earned cash operating cash flow (OCF), and the cash spent is capital expenditures (CAPEX). The cash generated is earned after including expenses associated with standard business operations.
FCF excludes non-cash expenses and includes equipment, capital, and assets — net income, on the other hand, does not. Net income tells you how much cash a business has generated without subtracting CAPEX.
What is CAPEX? Capital expenditures are spent on the purchase, maintenance, or improvement of fixed assets. Fixed assets your business owns may include buildings (for brick-and-mortar businesses), company vehicles, equipment, and land.
What is the ideal FCF?
Typically, the higher the FCF, the better. This means you have a lot of capital left over after factoring in CAPEX. But that doesn’t mean you should strive to hit some ridiculous number like $10 billion.
Moreover, this conclusion doesn’t account for long-term business investments that will pay off in the future. If a company has a bunch of capital tied up in these types of investments, the FCF is likely to be lower.
The goal is to grow FCF over time. If it’s constantly on the decline, your business is becoming unsustainable from a financial standpoint.
The key in looking at your FCF is that it consistently grows. There’s no target number you want to hit. Note that you will hit bumps along the way, after a significant business investment, for example. FCF is more of a long-term play and you want to analyze trends over time.
Why calculate free cash flow
Because FCF considers cash inflow after expenses associated with normal business operations, it gives a clearer and more accurate look at your ability to generate an ongoing profit. If it costs too much to serve a customer, you’re not operating a sustainable financial model.
Understanding FCF gives you true insight into how much capital you have left to reinvest in your business and pay yourself.
So, other than the business itself, who cares?
- Investors: People invest to make money. If an investor were to back a business that can’t turn a profit, that investment isn’t likely to deliver a strong ROI.
- Lenders: Much like investors want ROI, lenders want their money back — plus the interest owed. Without profitability, businesses have a harder time paying back loans.
- Creditors: If you’re opening a line of credit for your small business, creditors will also look at your FCF metrics to determine the legitimacy of your company and ability to pay your debts.
- Business partners: If you’re looking to attract a business partner to help you grow, they’ll want to see a healthy FCF to determine viability of the venture.
What happens when FCF changes
FCF fluctuates — dips aren’t always bad. Likewise, spikes aren’t always good.
When FCF increases
If your FCF is going up, this could be because of a number of reasons:
- Selling corporate assets
- Reducing CAPEX
- Accounts payable payments have been delayed
- Accounts receivable payments have been accelerated
- Cutting back on maintenance and marketing costs
- Delaying employee payments
- Recently closed a big deal and received a sizeable deposit
When FCF decreases
On the flip side, when you see FCF going down, this could be attributed to:
- Increase in working capital
- Large inventory order
- Equipment investments
- Rapid growth
How to calculate free cash flow: the free cash flow formula
To calculate the amount of FCF available in your business, use the free cash flow formula:
Free cash flow = operating cash flow - capital expenditures
Or, abbreviated;
FCF = OCF - CAPEX
Remember to use metrics from the same accounting period, or your results may be skewed and inaccurate.
Example FCF calculation
Let’s say you run a freelance photography business. For the year, you collected $350,000 in total payments from your clients. You spent $50,000 on things like website hosting, marketing your business, subscriptions for important software and tools, and other operating expenses. You also made a capital investment in new camera equipment for $5,000.
Your financials for the year would look like this:
- Total sales: $350,000
- Operating expenses: $50,000
- Capital expenditures (CAPEX): $5,000
Using the FCF formula, your calculation would go like this:
Free cash flow = operating cash flow - capital expenditures
To calculate the operating cash flow (OCF), we need to subtract operating expenses from total sales. In this case, it’d go as follows:
OCF = total sales - operating expenses
OCF = $350,000 - $50,000
OCF = $300,000
Now we’re ready to calculate the FCF.
FCF = OCF - CAPEX
FCF = $300,000 - $5,000
FCF = $295,000
So your FCF comes in at $295,000.
Moving forward with free cash flow
There are tons of accounting metrics you’ll want to familiarize yourself with as a self-employed professional. Understanding these numbers will help you track and improve profitability, as well as prove to third parties that your business is legitimate.
Track FCF over time using your accounting software and notice the fluctuations. What can you attribute to the changes in your FCF? How can you optimize FCF to increase profitability? Over time, you’ll have a better high-level understanding of your business so you can make strategic decisions to contribute to continued growth.