Free cash flow is one of the best predictors of a small business’s staying power.
Below, you’ll learn all about free cash flow, including:
- Free cash flow definition
- How to calculate free cash flow
- Why free cash flow is important to small businesses
- How to improve your small business’s free cash flow
- The difference between free cash flow and earnings
Let’s get started.
What is Free Cash Flow?
Free cash flow (FCF) is the cash a business generates after factoring in operating cash flow and capital expenditures (CapEx).
So, free cash flow is an excellent way to evaluate the cash inflows and outflows across a small business.
Free Cash Flow Formula
Here’s how to calculate free cash flow:
Free Cash Flow = Operating Cash Flow − Capital Expenditures
There are two ways to calculate operating cash flow:
Direct Method
OCF = Total Cash Receipts – Total Cash Expenses
Indirect Method
OCF = Net Income + Non-Cash Expenses + Change in Working Capital
Why is Free Cash Flow Important to Small Businesses?
Here are four reasons why free cash flow is important to small businesses.
1. Free Cash Flow Points to Changes in Receivables, Payables, and Inventory
As a small business owner, your receivables, payables, and inventory levels heavily impact your cash position.
Let’s say a small business experiences the following conditions over a period of one year:
- Increased receivables due to late payments by customers.
- Decreased payables due to strict payment terms with suppliers.
- Increased inventory due to poor inventory management.
All of the above would decrease free cash flow, and might be a leading indicator for future issues in the small business.
2. Free Cash Flow Points to Required Capital Expenditures
Capital expenditures are funds used to acquire and maintain physical assets like property, equipment, or technology.
If your small business has a high-dollar amount of required capital expenditures, only looking at operating cash flow is insufficient. Free cash flow and cash flow from investing factor in CapEx, though.
Here’s an example where CapEx is really important to a small business:
Chris starts a marketing agency and rents office space in Orlando, Florida.
In the first year, he buys computers and furniture for the office space.
In the second year, he buys three company vehicles.
In the third year, he doubles the size of his team… and buys more computers and furniture for the new staff.
For Chris, paying close attention to CapEx is necessary.
3. Free Cash Flow Measures Profitability of a Business
For a company with stability in current assets/liabilities and CapEx, free cash flow is a good way to measure profitability. This is because net income and non-cash expenses are the only components remaining (when using the indirect method).
In many cases, fluctuations in current assets/liabilities and CapEx even out over time, so the 5+ year FCF trend of a business is likely to be highly correlated with profitability.
4. Free Cash Flow is Important to Lenders and Investors
Lenders and investors look at free cash flow, so if you plan to seek equity or debt financing, your free cash flow is important.
Here are a few reasons why lenders and investors want to see stable/growing free cash flow:
- Higher likelihood of being able to satisfy future debt obligations.
- Ability to pounce on attractive opportunities for the small business.
- Free cash flow matters to most, if not all investors (important to investors if/when they sell shares).
Example: Free Cash Flow Analysis
Let’s look at a hypothetical company’s (let’s call it Blue Inc.) free cash flow over a five year period:
Year 1 = $100
Year 2 = $110
Year 3 = $121
Year 4 = $133
Year 5 = $96
From Year 2 through Year 4, Blue Inc.’s free cash flow grew by almost exactly 10% per year. Pretty good, right?
But what happened in Year 5?
In this case, you would have to dig deeper. Let’s say Blue Inc. made a $50 equipment purchase (CapEx) in Year 5. So, without that CapEx, the company would have grown FCF by almost exactly 10% again.
Does this mean everything is alright for Blue Inc.?
That’s hard to say. You would want to ask more questions, including:
- How long is this $50 piece of equipment expected to last? Is it going to need to be repaired/replaced in the near future?
- What are the projected future capital expenditures for Blue Inc.? Is this the first of many?
- What are the trends in Blue Inc.’s current assets and current liabilities?
This example illustrates a key point:
Free cash flow isn’t the be-all, end-all for analyzing the health of a small business.
Instead, it is best used as a starting point.
What is Good Free Cash Flow?
“Good” free cash flow depends on the specifics of a small business and industry norms.
In many cases, good free cash flow is stable/growing and the same/above industry norms. But this isn’t always the case.
Low free cash flow (as a result of CapEx) can be good if it’s expected to lead to increased free cash flow down the road.
High free cash flow, on the other hand, can be bad if a small business owner is not investing enough in the business.
How to Improve Free Cash Flow for Your Small Business
Here are a few ways to improve free cash flow for your small business:
- Be efficient with capital expenditures: consider the ROI on computers, furniture, vehicles, or any other types of CapEx before making each purchase. While CapEx lowers FCF in the short-term, good purchases can lead to increased FCF in the future.
- Collect payments faster and pay suppliers slower: by doing both of these things, you can potentially improve your free cash flow.
- Manage inventory levels effectively: if inventory accumulates, your FCF may decline.
RELATED: 10 Ways to Improve Cash Flow for Your Small Business
Free Cash Flow vs. Earnings: What’s the Difference?
Again, free cash flow is operating cash flow minus capital expenditures.
Earnings, on the other hand, is after-tax net income.
After-Tax Net Income = Revenue – Expenses – Interest – Taxes
Here are two big differences between free cash flow and earnings:
- Free cash flow includes CapEx. Earnings do not.
- Free cash flow does not include non-cash expenses. Earnings do.
The Bottom Line
Looking at a company’s free cash flow over the last five years is one of the fastest ways to determine the direction the business is going in.
And if you’re not satisfied with the direction of your small business, the components of the free cash flow calculation may be able to point you to areas for improvement.
But what if you need funding now?
In that case, consider Gravity Capital – we provide quick funding and allow you to repay the funds with the ebbs and flows of your small business.
