When you are running a business, recording cash inflows and cash outflows properly are important. After all cash management plays a vital role in determining what a company is left with at the end of every month, quarter, or financial year. However, most businesses ignore the free cash flow available to them. This is because they forget how instant these cash alternatives could be during emergencies.
Before exploring what this money means for business growth, let us discover what exactly the term means.
What Is Free Cash Flow (FCF)?
A free cash flow refers to the total amount a company is left with after covering its operating expenses and other costs. This becomes the sum that the firm can use at its own discretion without having to consult anyone as this amount totally belongs to it and is not invest by an investor or any stakeholder. As a result, the companies exercise complete right over the FCF.
Cash flow and free cash flow might sound similar, but they widely differ. While the former takes into account the total cash flowing in and out of the business, the latter is the amount of money a company is finally left with after covering the outstanding financial liabilities for a certain period. FCF is the money that businesses are free to use for whatever purpose they want.
Moving further, there are two types of free cash flows that a business might possess – levered and unlevered.
- An unlevered free cash flow is the FCF to the firms. This is the amount that the company has before it deals with the financial liabilities it has.
- A levered free cash flow is the FCF towards equity, which specifies the amount the business is finally left with after taking care of all its financial liabilities.
As a result, it is the levered FCF, which when recorded helps assess how efficiently a business is performing and how much it is saving after meeting all its expenses.
How To Calculate Free Cash Flow?
Calculating the FCF helps businesses get an accurate figure related to how rapidly it’s growing and how far it can expand. Hence, it is important to know the formula to use for correct calculation. The equation used for FCF includes:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
- Operating cash flow is the cash use to meet operating expenses of the business, which would include both net income and non-cash expenses and consider the change in the net working capital, accordingly adding or subtracting the latter from the former added value (i.e., Net Income + Non-Cash Expenses).
- Capital Expenditures include costs incurred to add, upgrade, or maintain the physical assets that serve to be the foundation of a firm’s production and sales.
In case, companies are unable to figure out the capital expenditure and operating cash flow, they can consider an alternative formula for calculating FCF.
- FCF = Sales revenue – (operating expenses + taxes) – investments required to maintain operating capital
- FCF = Net operating profit after paying all taxes – Net investment in operating capital
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How A Company Uses FCF?
Now that we know what FCF is all about and how it can be calculate based on the information available. The next thing is to explore for what purpose might a company use free cash flow. The FCF when calculate helps businesses understand their market position in terms of the figures they are left with after covering all possible expenses, relating to their financial obligations.
Here are a few ways to understand what it means for business growth and how businesses can use the free cash flow to assess their market position:
Figuring out the free cash flow lets the businesses explore whether they are moving on the right track. If the results are positive, it means the companies have made it through to the growth potential. A higher FCF signifies that the businesses have enough money to reinvest in their business without having to rely on investors out there to source their business procedures. On the contrary, a lower FCF implies that your business is not growing as expected and needs improvement.
Potential To Expand
When the free cash flow figures are more, it means the businesses have internal funds to expand their business the way they want. In such a scenario, they do not have to wait to raise funds or gather finances from other people or entities.
If you are an investor looking for a fruitful entity to invest in, analyzing FCF is of great help. How? You can study the financial statements of the company you have interest in investing in. If the FCF value is significant, it will automatically help you know the rate at which the company is growing. You can compare the FCF now with FCF then (for any previous specific period) and decide whether it is the option you should proceed with investing or look for other options.
Whether you should restructure your business for improvement or you should continue with the same is a question that can easily be answer when you get to unveil your FCF. If the value is high, you know that you can continue with the existing structure. On the contrary, if the value is not adequate, you understand automatically that you need to restructure your business to make it more efficient.
Calculating or figuring out the exact value of free cash flow helps businesses assess their productivity and stability in the market. In accordance with what the value conveys, the firms can make required decisions for improvement and keep growing. In short, FCF lets them enhance their growth rate if analyzed well and utilized properly accompanying the same with the required actions.
Are you struggling with tracking your business’s efficiency? If yes. Get in touch with us today! Our accounting professionals record your free cash flow figures accurately, which you can rely on to make effective business decisions. Not sure, if you should have us onboard? Talk to us to explore.