When running your own business, you’ll come across many unfamiliar terms, especially if you don’t have a lot of experience in finance.
One of those terms you might have heard thrown around is ‘free cash flow’. It’s a phrase you might come across a lot, and it can have many different benefits to your company if you learn how to work it out and apply it to your business operation.
So what is free cash flow? This article will dive into the following areas to answer that very question:
- What is cash flow?
- What is free cash flow?
- Why is free cash flow important?
- How to work out your free cash flow?
What is cash flow?
Let’s start by breaking down what ‘cash flow’ itself is. The stream of money flowing in and out of your business is your cash flow. The cash you receive is called inflows, and this can be the invoices paid by your customers. The money you spend is referred to as outflows, and this can be any money paid out to your suppliers or money owed to the bank.
Generating positive cash flow is the goal of every business. Positive cash flow means your company’s liquid assets (your accessible cash in the bank) increase so you can pay your expenses, debts and create a buffer against future financial challenges.
If you consistently generate a positive cash flow (where your liquid assets are increasing), your business has a greater chance of succeeding without relying on funding or investments. On the other hand, a sustained negative cash flow means you’ll likely struggle to make ends meet in the future.
What is free cash flow?
So free cash flow is the cash that a company is left with after paying for its operating expenses and capital expenditures.
Operating expenses can include:
- Rent or mortgage on business property
- Cost of goods sold (what it costs for you to make or source your products)
- Taxes (if you set your money aside for paying your VAT or income tax bill)
Any cost that is associated with running the business can be counted as an operating expense.
Capital expenditures are the purchases of assets (usually fixed assets) that will be used by the business long term, for example, heavy machinery or vehicles. If the item will be useful to your business for more than two years, it can be counted as a capital expenditure. This can include items that are higher in value, such as laptops or computers, and specialised equipment, property or a business car.
So free cash flow is the money left over once you have paid the costs associated with the above expenses. If you are left with a positive figure, your business is free to do what you like with that money, as it is not owed to a creditor.
Why is free cash flow important?
Understanding your free cash flow is essential as it supports financial management within a company. Figuring out your cash flow will first show you the financial health of your business and your ability to pay what you owe to run the business. Then examining your free cash flow will give you more insight into the financial situation of your business and support in making decisions about investment or growth.
Free cash flow, in particular, is an important measurement to keep track of because it shows how efficient your business is at generating cash. If you were looking for investors, they might want to see this figure, so they could understand your ability to pay back dividends or buy back shares. Plenty of free cash flow also is attractive for investors as it shows that you have cash available to pursue opportunities that can improve your business.
Your free cash flow total also accounts for changes in the working cash you hold, whereas a profit and loss statement and other financial reports may not reveal this information.
For example, you might have higher free cash flow one month due to a decrease in your outflows. A reduction could mean that your vendors or creditors require faster payments than usual. Your inflows could also fluctuate. For instance, if your accounts receivable (the money owed from your customers) is lower, your business is getting paid by clients quicker.
Increases in your outflows could also reveal some issues, such as a higher inventory total could show that you are struggling to shift stock.
This free cash flow total shows the profitability of your business at any one time. Knowing the ins and outs of your finances will help you improve the business and make wiser decisions because you are equipped with a complete picture of your finances.
How to work out your free cash flow?
So how do you work out your free cash flow total?
First, calculate your net income. This is the total of all your sales, minus the operating expenses (the costs associated with making the sales). This figure will be on your cash flow statement or your income statement.
Then you should total up the capital expenditures. You’ll find this total on a balance sheet, and it’s the cost of all your fixed assets.
The formula for your free cash flow is:
Free Cash Flow = Net Income − Capital Expenditures
And this remaining total will show how much money your business has to play with once your operations and assets are paid for.
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The app automates a lot of the time consuming manual tasks associated with running a business. For example, it can help you create invoices in seconds, reconcile invoices once paid, and automatically categorise your expenses. It also shows you real time insights into your profit and loss, your cash flow and tax estimates, so you’ll always know how much you owe HMRC.
Countingup is saving business owners hours of time-consuming work and helping thousands keep on top of their finances. Find out more here to save yourself hours of accounting and financial admin, and get back to what you do best – running your business.