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Free Cash Flow Explained for Business Owners

Free cash flow is an important financial metric. Learn how to calculate free cash flow, why it is important and how it can be improved.
Free Cash Flow Explained for Business Owners

They say cash is king.

In that case, for business owners, free cash flow is king. Let’s look into why free cash flow is important, how to calculate free cash flow and how you can improve free cash flow for your business.

Why Free Cash Flow is Important

Okay, first it’s important to answer the question “what is free cash flow?”, so we all know what I’m talking about here.

Free cash flow (sometimes you’ll see it shortened to FCF) is the money a business generates after considering all the investments it needs to make to continue operations and maintain its assets. These investments include your working capital needs and spending on fixed assets.

It is an important metric because it represents the money that you can actually take from your business and use for other purposes. For example, to invest in growth or pay to yourself and other owners.

Let me use an example to make it real:

Your local pizza shop has an operating cash flow after tax of $75,000 for the year. Many people think this is what the owner takes home as earnings, which is not quite correct. Let’s say that net profit after tax was also $75,000, so there was no depreciation or amortization this year.

To operate the business during the year and have it ready to serve customers next year, the owner needed more inventory, to refresh the restaurant fit out and upgrade the pizza oven. This all combined to be $25,000 in capital the owner needs to contribute (outside of all other expenses already included in the operating cash flow figure).

To calculate the free cash flow we take the $75,000 in operating cash flow after tax and subtract the $25,000 in capital expenditure, giving us $50,000 in free cash flow (75,000 - 50,000).

The owner must make that investment, otherwise they would not have generated $75,000 in cash this year, and the business would not be capable of generating the same next year. So the actual money available for the owner to take home as earnings was $50,000, not $75,000.

This is why free cash flow is so important, and why you should calculate it, monitor it and look to improve it at every opportunity.

How to Calculate Free Cash Flow

To calculate free cash flow, you start by taking your operating cash flow (after tax) for the year and then subtract the capital expenditures you need to make to keep the business running. Here’s the formula:

Free Cash Flow = Operating Cash Flow After Tax - Capital Expenditures

where:

Capital Expenditures = Increase in Working Capital + Maintenance Capital

Nowadays, your bookkeeping or accounting software will calculate free cash flow for you automatically. But It is still important to understand how it is calculated so you can interpret the results and understand its drivers.

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How to Improve Free Cash Flow

We can find ways to improve free cash flow by looking into its drivers. Looking at the formula used for calculating the metric, we can determine that there are two drivers of free cash flow:

  1. Operating cash flow after tax, and
  2. Capital expenditures.

Using our pizza shop example, imagine that we could increase operating cash flow after tax to $100,000 and reduce capital expenditure to $20,000 (say by finding a novel way to do the updated fit out). Free cash flow will improve from $50,000 to $80,000!

So we can increase operating cash flow after tax or lower capital expenditure, and the free cash flow will improve. Let’s look at some ways we can do this:

To increase operating cash flow after tax we can:

  • Increase revenue by lifting prices.
  • Increase revenue by generating a higher sales volume.
  • Reduce the cost of goods sold by finding ways to use less inputs, for example by reducing usage or improving processes.
  • Reduce the cost of goods sold by reducing the prices paid for your inputs, for example by negotiating with suppliers for lower prices or discounts.
  • Reduce expenses by finding ways to reduce sales and marketing expenses, utilizing employees more efficiently and looking into ways to reduce all other costs (e.g. insurance, rent, utilities, etc.)
  • Reduce interest payments by refinance loans on better terms.
  • Reduce taxes

To reduce the capital expenditures required you can:

  • Reduce working capital requirements by improving inventory management or renegotiating payment terms for accounts payable.
  • Reduce maintenance capital required by extending the life of assets, or finding novel ways to reduce capital works bills.
  • Reduce total assets by replacing expensive equipment with equally serviceable but cheaper alternatives, selling idle assets or participating in sale and leaseback opportunities.

Always get advice on these matters. If you can reduce required capital expenditures it means you can release funds from your business to invest in other opportunities, and generate growth or pay dividends. A win-win if you manage it correctly.

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Key Takeaway

For business owners, free cash flow is a key measure of how much money your business is actually generating. Money that can be put towards growing your business or paying cash dividends to owners.

You should continually monitor your free cash flow, look for ways to improve it, and then have plans in place to sustain those improvements.

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