Resources | Cash Flow Management | 18 August 2022

What is Free Cash Flow and Why Is It Important?

Free cash flow can indicate your business’s financial health and help you track progress. But what is free cash flow exactly? And why is it so important?

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Free cash flow can indicate your business’s financial health and help you track progress. But what is free cash flow exactly? And why is it so important?

Cash flow issues and inadequate money management are consistently named as some of the top reasons that small and mid-sized businesses fail. In fact, research from US Bank showed that 82% of businesses that fail do so because of cash flow problems.

Therefore, it’s vital to sharpen your cash flow forecasting ability and develop a solid understanding of key cash flow metrics. Free cash flow (FCF) is a key indicator of your company’s financial health and desirability to investors, and it is arguably one of the most important metrics you should be tracking.

Below, we’ll cover what free cash flow is, why it’s so important and what it can tell you about your company’s financial performance. Read on for an in-depth explanation of FCF or click below to navigate to the section of your choice.

  • What is free cash flow?

  • How do you calculate free cash flow?

  • What types of cash flow are there?

  • Why is free cash flow important?

  • What can free cash flow tell you about your business?

What is free cash flow?

FCF is a common measure of a company’s financial performance and indicates how much cash you have remaining after paying for day-to-day operating costs and capital expenses. Put simply, it is operating cash flow less capital expenditures. Note that it excludes non-cash expenses such as depreciation or amortisation.

For further insight into FCF, you should first understand two important financial statements: the cash flow statement and the balance sheet.

Cash flow statement

A cash flow statement is a key financial statement that provides aggregate data of all the cash inflows and outflows of your company.

Balance sheet

The balance sheet is a financial statement that tracks your company’s assets, liabilities and stockholder equity in a given period. It offers a snapshot of what your business owns and what it owes, as well as amounts invested by owners.

How do you calculate free cash flow?

There are two main components from your financial statements you will use to calculate free cash flow. First, you’ll need to calculate operating cash flows and total capital expenditures. These can usually be found on your balance sheet and cash flows statement. Once you have both of those numbers, the easiest way to calculate free cash flow is:

For example, let’s say a small tech company reports a total of $400,000 cash from operations on its annual cash flow statement. In that same year, the tech company spent a total of $100,000 on equipment or capital expenditures.

Here’s how the tech company would calculate its FCF using the above formula:

(Operating cash flow) $400,000 – (capital expenditures) $100,000 = $300,000 FCF

In this case, the tech company’s free cash flow is $300,000.

Alternatively, you could use a slightly different free cash flow model, which calculates FCF by adding net income to non-cash expenses (depreciation and amortisation) and then subtracting the change in working capital and capital expenditures. For this more complex formula, you’ll need to use your income statement and balance sheet, and calculate working capital by subtracting liabilities from assets.

What types of cash flow are there?

There are three types of cash flow that companies typically monitor and analyse to gauge the financial performance of their business: cash flow from operating activities, cash flow from investing activities and cash flow from financing activities. A cash flow statement generally contains all three. Here’s a more detailed explanation of each type:

  1. Operating activities

Operating cash flow refers to the amount of cash generated by your day-to-day operating activities — for example, manufacturing, sales or providing a service to customers — within a specific time period.

  1. Investing activities 

This pertains to cash flow related to the acquisition and disposal of assets and other investments not included in cash equivalents, which could be purchases of assets like property and equipment, stock investments or acquiring another company.

  1. Financing activities 

Cash flow from financing activities involves the net change in cash associated with funding the company. This includes any transactions involving debt, equity and dividends.

Why is free cash flow important?

There are many benefits of free cash flow to you as a business owner as well as for potential investors. Here are some of the key benefits to consider:

For business owners like yourself:

  • Free cash flow is important because it’s a reliable measurement of how efficient your company is at producing cash from your regular business activities.

  • It can also be an extremely useful early indicator of the potential for cash flow shortages ahead, and this can help you determine when to take steps toward improving cash flow before it’s too late.

  • Additionally, it is a useful way to determine how your company’s cash flow is impacted by your capital expenditures.

  • It represents the money available to develop your business, amplify product offerings, and take on other opportunities or projects that increase your company’s long-term value.

  • Think of it as the “free and clear” income you have available after satisfying all your internal and external obligations.

  • It’s challenging to launch new products, reduce debt, pay dividends and make acquisitions without a healthy supply of cash.

For investors and business analysts:

  • Free cash flow is important to investors and business analysts because it shows how much cash your company has at its disposal.

  • They often assess your free cash flow to determine whether your company has enough cash to repay debts, issue dividends and buy back shares.

  • Some investors prefer using free cash flow to measure a company’s financial performance because free cash flow is more difficult to manipulate with “creative” accounting than other metrics such as net income or earnings per share (EPS).

What can free cash flow tell you about your business?

Free cash flow can offer great insights into the performance and ongoing prosperity of your business. Here are a few important things that free cash flow can reveal:

  • How you’re doing financially

Positive free cash flow can indicate you have plenty of cash left over to pay bills or investors, or to reinvest in new opportunities. In contrast, when it’s negative, it can mean your business isn’t generating enough cash to support growth.

Even so, it’s important to mention that negative free cash flow isn’t always a bad sign. For example, it could indicate that your company is heavily investing in growth that could potentially result in high returns and pay off in the long run. On the other hand, excessive positive free cash flow can signal that your business is holding its assets idle rather than reinvesting them for growth.

  • Whether you should expand

When free cash flow is positive, it can tell you that you’re well-positioned to invest in scaling your business. This can mean almost anything, from acquiring a competitor to launching a large-scale marketing campaign, investing in new technology or even opening a new location.

  • How attractive your business is to potential investors

Free cash flow is considered one of the best and easiest metrics to determine whether an investment is good or bad. This is because consistently strong positive cash flow can indicate the potential for increased profitability, which can yield promising returns for the investor, therefore making it a more enticing investment.

  • Whether you need to restructure

If your business is in a high-growth phase, you may experience negative free cash flow due to increased costs associated with expansion. However, if you find your free cash flow is frequently low or negative, that can signify it may be time to restructure operations or boost your capital by offering early payment on your invoices, selling equity, investing more of your own money or taking on additional financing.

Ultimately, having more free cash flow on hand provides more opportunities for you and your business. Here are just a few ways to put that cash to work:

  1. Pay your shareholders or yourself a distribution as a reward for your positive results.

  2. Invest in another business, preferably one with a healthy amount of free cash flow itself.

Reinvest in the primary business. You can spend cash to develop an alternate product line or, more commonly, buy back discounted ownership shares. Or you could also invest in expediting slow accounts receivable collections, freeing up working capital to grow revenue, reduce debt or add to inventory.

The bottom line

Though revenue growth and profitability frequently capture the headlines, it’s often the less commonly known financial measures such as free cash flow that best paint a picture of your business’s health. This is because it is a metric that can help you assess your company’s present value, so you can track growth, encourage expansion and avoid failure. Furthermore, in times of economic uncertainty, a solid supply of free cash flow can make your business more resilient to financial pressure and put you in a better position to ride out the downturn.

Because free cash flow easily answers the “What’s in it for me?” question, lenders, investors, prospective buyers and business brokers will have a strong desire to know this metric. By having a ready answer to the “What’s your free cash flow?” question, you’ll instill confidence in others and prove that you do indeed know your numbers.

Seeking ways to boost your business’s free cash flow? Discover how accepting early payments on your invoices can help you get paid faster and improve your free cash flow on a daily basis.

This article originally published June 30, 2021, and was updated August 18, 2022.

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