Your free cash flow is a key indicator of your company’s financial health and as a result its desirability to investors. The free cash flow calculation is one of the most important results from your cash flow analysis that you, as a small business owner, can take away from the analysis of your company’s statement of cash flows.

What is free cash flow?

Free cash flow is the amount of money your business has leftover to use for other purposes such as paying investors after you’ve paid for expenditures such as buildings and equipment, as well as operating expenses that are necessary to sustain your business.

It’s important to calculate your free cash flow accurately so that you can make the best decisions for your business going forward. Investors will look carefully at your business’s free cash flow to make sure there’s no possibility of company fraud.

It’s not as easy to manipulate free cash flow as earnings per share or net income. The calculation process can be a little complicated and there are several methods to get it done. But if you use these methods correctly, then they should all come up with the same answer. This gives you a great way to double-check your work!

Three ways to calculate free cash flow:

These three ways to calculate free cash flow are among the easiest to use, and they’re also known as free cash flow to term. Here are the three methods:

Method 1

Free cash flow = sales revenues – operating costs and taxes – required investments in operating capital

This equation involves taking the sales revenues, operating expenses, and taxes away from the business’s income statement. Investments in new operating capital show up as increases in fixed assets on the business’s balance sheet.

For example, if your business has sales revenue of R500 000 then this figure might be reduced to R200 000 by R300 000 in operating costs and taxes due. If your business’s required investments were R150 000 then your free cash flow would be R50 000.

Method 2

Free cash flow = net operating profit after taxes (NOPAT) – net investment in operating capital

NOPAT is the same figure used in the first equation: sales revenue minus operating costs and taxes. Net investment in operating capital is the same figure as the third term in the first calculation. You can also use the increase in fixed assets on the balance sheet.

For example, your NOPAT remains at R300 000 and you’re simply exchanging the required investments in operating capital for your net investment in operating capital. Assuming they’re the same, then your free cash flow should also remain the same.

Method 3

Free cash flow = net cash flow from operations – capital expenditures

Net cash flow from operations comes from the first section of the statement of cash flows in this equation, while capital expenditures come from the increase in fixed assets off the balance sheet. For example, if your net cash flow from operations is R200 000 then this figure would be reduced by your capital expenditures.

The effect of free cash flow

If your business has a positive free cash flow, then that’s a great indicator of overall business health. Companies that have a healthy free cash flow will have enough funds on hand to pay their bills on time every month plus excess.

This excess can then be distributed among shareholders as dividends or it can be used to seize upon opportunities to generate even more income through acquisitions or developing innovative products.

If your company has a rising or high free cash flow then its generally doing well and you might want to consider expanding. However, if your company is falling or it has a low free cash flow, then you might need to restructure because there’s no money remaining after covering the essential bills.

Having said this, low free cash flow is not always indicative of a failing business. It can also be expected at times when a healthy company is actively pursuing growth. Acquisitions and new product development can temporarily subtract from the bottom line.

Investors can even lookout for companies with rapidly rising free cash flow because these companies tend to have excellent prospects. If investors find a company with rising cash flow and an undervalued share prices, then this means it’s a good investment and can even be an acquisition target.

Summary

As a small business owner, you must remember to look beyond the numbers. Keep in mind that older, more established companies tend to have a more consistent free cash flow. Whereas new businesses are typically in a position where they’re pouring money into stabilisation and growth.

It’s up to you as the business owner to decide how you want to use your free cash flow. The funds you bring in can be used to expand the business, pay dividends to shareholders, reduce debt, or even invest in research for new products or other means of expansion.