Free cash flow is a financial indicator that is favoured over ROCE, ROI and other ratios to gauge a company’s health.
So it’s important for entrepreneurs to understand how important it is in their business.
Free cash flow is how much cash is left in the business after all running expenditures, taxes and capital expenditure.
It is the cash available for paying dividends, reducing debt or starting new projects to grow the business, i.e. it’s cash in the bank and free to spend as the owners/directors wish.
If the free cash flow is positive it means that the business generates more cash than it needs to run and re-invest to grow the business.
Everyone knows cash in the bank is the most important indicator in a business – well nearly everyone realises that but some still consider profits and worst of all sales to be more important.
Calculating the free cash flow is easy and can be derived by using the Income, Balance sheet and cash flow statements.
Free cash flow = EBIT (earnings before interest and tax) – Corporation tax – Capital expenditure – Change in working capital (from previous period to current period).
The individual figures for this are taken from the Income statement (EBIT and corporation tax), Balance sheet/Cashflow statements (Capital expenditures and change in working capital).
Free cash flow (FCF) has been used for many years by investment analysts, FDs’ and VC’s to evaluate the health of a business and how much positive cash it can generate.
So it’s important to know the figure for your business.
The figure can be either positive or negative. Here are a few situations to on why free cash flow is so important and what it could mean.
1. FCF is positive and the projections show it growing – good business with growing earnings and capable of paying dividends or investing into new projects to further increase profits.
2. FCF is negative but projections show it to be positive – one negative could mean that a large investment has been made in a project or acquisition or it’s a startup with heavy investments.
3. FCF trends in past periods are variable – could mean that irregular investments are being made or working capital is not under control, i.e. took much debtors in a period.
4. FCF is negative and shows no sign of moving to positive – the business could be in trouble.
Free cash flow is one of the key indicators for potential investors and VC’s to evaluate whether to invest or not. In stock markets, free cash flow yield (free cash flow divided by the market capitalisation of the company) is thought to be a better indicator than the price earnings ratio to evaluate the health of a business.
So it’s worth getting to know the free cash flow figure in your business and if your business prepares regular cash flow projections, it should be easy to work it out and be ahead of the game.