At Smansha, we often talk about how cash flow is the best indicator of your business’s financial health. (And we truly mean often.) But there’s a metric within the bigger umbrella of cash flow that drills down on your survival odds as a company: Free cash flow.
Free cash flow lets your business really see what kind of cash your company has available to work with after it pays for operations and capital expenditures. It’s a bit less straightforward number than just looking at an income statement. But, if you do the legwork, like running regular cash flow forecasts using our insights and analysis, you’ll have an invaluable perspective on whether your business has the runway to invest — and the potential to grow.
Free cash flow defined
Most simply, free cash flow is the remaining portion of your business’s cash flow that you can safely access after the necessary expenses are paid for. Most often, it’s mentioned into context what you can “distribute.” But as a small business owner, you don’t need shareholders for that to be relevant.
Distributions include payouts to equity holders (including yourself as the proprietor of a business), but also those who hold debt (like any business lenders or other debtors), and any investors if that’s relevant for you, too.
Importantly, free cash flow is a short-term metric.
How to calculate free cash flow
Grab your most recent cash flow statement. There are a few different ways to calculate free cash flow, but the most straightforward among them is:
Net Operating Cash Flow – Capital Expenditure = Free Cash Flow
Wherein operating cash flow (OCF) means:
- Cash you make from business as usual, minus your long-term investments and taxes.
- OCF takes into account depreciation expense by adding it back in.
- You can find your OCF number on your cash flow statement.
Wherein capital expenditures (Capex) means:
- Cash you’ve spent on capitalized fixed assets, including expanding, upgrading, or maintaining your systems, equipment, space, etc. for business
- Capex takes into account depreciation expense by adding it back in
- You can find your Capex number on your cash flow statement in the “investing activities” line
How free cash flow differs from net income
If this sounds a bit like your net income, you’re not off base — but free cash flow has an important difference. Your net income takes into account depreciation. (The free cash flow formula adds depreciation back in, as you can see reflected above.)
For instance, say you make a big purchase on a commercial oven for your organic granola company. But you have to pay for it all up front. Although your net income, which you pull from your income statement, will give you one number that factors in depreciation, your free cash flow will indicate a different total. Since your free cash flow gives you a snapshot of the short term, you’ll see a more constrained cash flow number because you paid in a lump sum.
Depreciation is set up within the mechanisms of accounting by design to lessen the blow of a big asset purchase. (The IRS’s term for this deduction is “cost recovery.”) On the other hand, free cash flow’s this-very-second approach to your spending makes sure your costs are recorded as they happen — that’s why depreciation is handled differently. In short, with cash flow, you want to see how that big expenditure affects your bottom line ASAP.
What your company’s free cash flow can tell you
Free cash flow is meant to be a short-term metric — and it is. You can learn a lot about your financial solvency as a company, both the now and future, if you contextualize your numbers correctly.
Free cash flow in the short term
Calculated once, your free cash flow gives you a pretty solid sense of your business’s true liquidity or ability to meet its current and near-term financial obligations. And that’s important. If you’re planning to distribute earnings or wages (including to yourself — an entrepreneur can only eat so much ramen). You also need to be able to do so knowing that it won’t happen at the cost of keeping the lights on.
Plus, if you have outstanding business loans — or even business credit card bills — understanding what you’re able to siphon off your cash reserves is essential. Especially if you have something like a business line of credit, wherein you have, say, a six-month window to pay back what you borrowed. Knowing you have the cash to pay back your lender now means you don’t have to worry about extra fees, penalties, or interest.
Free cash flow in the long term
As with most financial metrics — and data in general — the more free cash flow calculations you have, the better. If you see an upward trend in your company’s free cash flow, it’s a strong hint toward growth. It also gives you the opportunity to invest and reinvest in your company.
Since no one number tells a complete story, you’d have to dig into P&Ls and balance sheets to figure out what’s going right. Maybe you’re doing a good job at keeping your costs low as you’re able to increase your prices relative to market competitors. Maybe you’re expanding your customer base and lowering your customer acquisition cost (CAC) in the process. Whatever you’re doing, consistently increasing free cash flow generally indicates positive financial health.
On the other hand, a downward trend in free cash flow over a longer period of time will be able to raise your red flag. Why are you experiencing an earnings decline? Are you managing your assets efficiently and investing the right way? (And do you need help turning things around?)
Why free cash flow matters
If we asked you, How’s your business doing? You’d have one answer to the question. If we asked an outside evaluator to come in, thumb through your exact same financial statements, and respond to the prompt, they’d very likely have something different to say. It has nothing to do with you. Rather, there are lots of ways you can read and interpret the stories your financial statements tell.
Cash flow is already among the least gray financial metrics to interpret. Your cash position paints a straightforward picture — either you’re cash flow positive or cash flow negative. (And the more work you do creating cash flow forecasts with insights from Smansha, the quicker you can make adjustments so the latter never happens.)
But even within cash flow, there’s something called a cash “smoothing” effect which can change the accuracy of your cash reporting. Some businesses use accrual basis accounting (versus cash basis), which reports and records both revenues and expenses as they happen, not when they’re received or incurred. That can sometimes cause a less accurate representation of their short-term cash. This is that smoothing, which essentially spreads (aka smooths) this cash data out over a longer period of time.
The numbers your accounting data provides is still entirely accurate in terms of net income — don’t worry. But free cash flow takes into account that smoothing and attempts to mitigate it. As a result, it’s harder to manipulate.
Hence, free cash flow is an even more precise way to get a sense of a business’s available cash. (It’s even a favorite metric for investors evaluating Wall Street securities, so you’ll be in good company using it.)
Gathering as much cash flow data as possible
If you research more about free cash flow, you’ll find there are quite a few more ways to calculate it and apply it to corporate finance. We’ll advise you not to worry about the others as a small business owner. (They’re a bit more in the weeds, geared toward huge public companies with lots of shareholders.) Just the general overview of free cash flow will be enough for you to understand more about your business’s assets at a deeper level.
That said, we did say more data is better, right? And we stand by it. Because there are many cash flow insights that are immensely helpful for you to make better data-based decisions every day as a business owner.
Smansha’s cash flow forecasting tools provide the deep, nearly up-to-the-minute numbers to help you make the best calls for your company by pulling your latest financial information directly from your accounting software.
Signing up is easy, and QuickBooks Online users can connect easily connect their businesses. (Not a QBO user? More integrations are on the way, too.)
The information in this article is not financial advice and does not replace the expertise that comes from working with an accountant, bookkeeper or financial professional.
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