Free Cash Flow

Free cash flow is the amount of cash a business generates, less the cost of maintaining operations and capital assets.

Many businesses focus on income statements and profitability as financial performance indicators. However, free cash flow is a crucial measure of a business’s capacity for making smart growth investments. It can also signal cash shortages that could negatively affect business success.

What is it?

Free cash flow (FCF) is the amount of cash a business has after accounting for cash outflows, including everyday business and capital expenses. It doesn’t include noncash expenses or interest payments. It’s used to repay creditors, pay shareholders and make growth investments. 

Levered free cash flow vs. unlevered free cash flow

FCF often distinguishes between levered free cash flow (the amount of cash available after paying debts) and unlevered free cash flow (the cash available before debt payments). Levered cash flow indicates how much cash a business has left over to pay investors and make growth investments.

How to calculate this KPI

Here’s how to calculate it:

For example, imagine that last year Supplier A earned $800,000 in revenue and spent $200,000 on operating expenses, leaving it with $600,000 in operating cash flow. The same year, it spent $100,000 on capital expenditures, including equipment purchases, facility maintenance, and research and development. After factoring in the cost of these capital expenditures, the supplier generated $500,000 in FCF.

FCF doesn’t consider only revenue from everyday business activities such as sales. Businesses can calculate this KPI based on the revenue generated from:

• Operating activities, such as the sale of goods and services.
• Investing activities, such as acquisitions, stock investments and real estate.
• Financing activities, such as equity transactions and dividends.

Positive free cash flow indicates that a business has excess cash to cover bills, make dividend payments to shareholders, and invest in R&D and growth. However, too much can mean that the business is missing out on investments that could offer future returns. On the other hand, while negative free cash flow often signals that a business lacks the cash required to grow, it can also indicate that the business is already investing in growth and hasn’t yet realized the returns.

Why is this important? 

Free cash flow is one of the most important financial metrics that businesses can use to monitor financial health. This is because it accounts for a business’s working capital, which illuminates financial instabilities that would otherwise be hidden in other financial metrics, such as an income statement.

For example, imagine that for the past five years, Supplier A’s income statement has consistently reported a growing net income. The business seems to be profitable, but for the last two years, its buyers have extended payment terms — sometimes as long as 120 days. The supplier’s income statements make the business appear lucrative, but longer waits to receive cash payments from buyers are significantly decreasing its free cash flow. In this case, the supplier could increase it by negotiating shorter payment terms, or it could leverage an early payment solution such as C2FO’s Early Pay program.

For these reasons, FCFd is valuable for:

• Evaluating and predicting cash shortages.
• Ensuring that the business can minimize debts and pay its investors.
• Deciding when a business can responsibly make growth investments.
• Identifying and addressing the source of low cash flow, such as extended invoice payment terms.

Many investors prioritize this metric — expressed as free cash flow yield — when evaluating a business’s financial health. That makes it an important measure for businesses seeking potential investors.

The benefits of FCF

• Understand a business’s financial health. Free cash flow offers critical financial insights that are often unnoticeable in other metrics.
• Prepare for cash shortages. FCF can indicate the early signs of declining cash flow, even if the business otherwise seems profitable on an income statement.
• Make smart growth decisions. Businesses that track FCF have a clearer picture of when it makes the most financial sense to invest in growth or hold on to cash.
• Attract investors. Maintaining a healthy FCF gives potential investors peace of mind that a business offers promising returns.