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Free cash flow is the money your business has available after paying all of your business expenses. So that’s the cash leftover after rent, bills, taxes, and employee salaries. It’s vital that you understand this number if you’re a business owner, because it can help you understand if you’re making enough money.
- Positive free cash flow is an indicator of a successful business that has the potential for continued growth.
- If you have investors, positive free cash flow means profit in their (or your) pockets.
- Free cash flow is fairly easy to calculate and can show you if you’re hemorrhaging money or there’s any fraud occurring.
How to Calculate Free Cash Flow?
There are three different methods when it comes to calculating free cash flow. Companies have different accounting methods and financial statements on hand, so each method takes this into consideration. All in all, calculating your free cash flow is fairly simple and can be done with just a few forms.
- Using Operating Cash Flow. This is the simplest formula that most businesses should be able to use. The formula is: operating cash flow − capital expenditures = free cash flow. You’ll find both the operating cash flow and capital expenditures in your cash flow statement, something all businesses should have readily available.
- Using Sales Revenue. This method involves looking at your yearly or monthly sales revenue and subtracting all of the costs it takes to make that revenue. The exact formula is: sales revenue − (operating costs + taxes) = free cash flow. Anything that is absolutely required to run your business is considered an operating cost, taxes included.
- Using Net Operating Profits. This method is similarly to the revenue method above, except it focuses on your profits after taxes have been taken out. The formula is: net operating profit after taxes − net investment in operating capital = free cash flow.
See small business cash flow management for further details on how best to oversee cash flow.
Why is Free Cash Flow Important for Your Small Business?
Small business owners need to keep a close eye on their finances in order to properly manage their money. Calculating your free cash flow is just one step in this process. Free cash flow is also important for all businesses because it:
- Helps businesses see pain points. Free cash flow can help you understand how your business is doing financially. Positive cash flow can indicate a growing business (see cash flow projections for more in-depth information), while negative cash flow can help you understand where you need to make cuts.
- Helps investors understand how your business is doing. If you’re a public company or a company that has investors that expect dividend payments, knowing how much free cash flow you have can help them understand how much they can expect to earn in dividends.
- Helps you detect potential fraud. Negative cash flow isn’t always a bad thing, but at times it can indicate an accounting error. Once you catch on to this, you can take action and adjust.
Limitations of Free Cash Flow
If you’ve calculated your business’s cash flow and you end up in the red, there’s no need to panic. Negative cash flow isn’t always a bad sign, it just means you need to adjust. Plus, free cash flow calculations are going to vary for a number of reasons. Here are a few limitations to free cash flow equations:
- They’re generalized calculations. Free cash flow calculations are meant to be simple, so they’re not going to show your entire business picture in a single number. They’re general estimates that help you understand what you have for money coming in and out.
- Newer businesses are going to have lower cash flows. The age of your business is going to play a key role in your free cash flow. Larger, more established businesses are more likely to have greater free cash flows simply because they have a large customer base and have had more time to grow. Smaller businesses on the other hand are likely to have negative free cash flows because they’re still in the growing stages.
- Calculations will vary greatly from industry to industry. A small business is going to have a wildly different free cash flow than a large corporate company. Many larger businesses need to spend more money on equipment and labor, while small businesses simply don’t have the same expenses. Check out expenses of a small business for more details.
How to use Free Cash Flow to Grow Your Business
Knowing how much money your business has left over after all expenses can do more than just make you feel good. It can also help you grow your business and make the right financial moves to keep your business on track. If you’re looking to grow your business, here’s why knowing your free cash flow can help:
- Free cash flow helps you understand your overall business health. While free cash flow is by no means the only indicator of success as a business, it can help you understand how your business is doing monetarily. Once you get a sense of how healthy your business’s finances are, you can move in the right direction to make improvements.
- You can use the extra cash to add employees or buy new equipment. Having extra money leftover at the end of the month or year can help you ramp up your business, if you wish to do so. If you need extra employees or more equipment or a better workspace, if you know you have extra cash on hand, you can confidently add these elements to your business.
- You can use it to restructure. If you find that you have a negative cash flow, you can use this information to adjust or restructure your business in a way that increases your free cash flow.
- You can potentially gain investors. If you can offer dividends through your free cash flow, you can go a long way in attracting investors. This can increase demand for your business which can, in turn, boost your cash flow even more.
Calculating your free cash flow isn’t a one-time process. Each year (or a few times a year), you’ll want to check-in and get a sense of where your business stands financially. Use whichever cash flow formula works best for you and make sure to keep your financial records in order so the process is as easy as possible.