Free cash flow is one of the most widely used tools analysts use to assess a business’s financial health. Like many financial metrics, free cash flow is used by both investors and industry professionals alike. This is because it is a practical form of analysis that can be helpful for many stakeholders.
In this post we will cover what free cash flow is, the various ways to calculate it and how to interpret the results.
What Is Free Cash Flow?
Free cash flow, often referred to as “FCF”, is a formula for calculating the excess cash a business generates through its normal course of operations. This means that FCF is a reflection of the true cash-creating potential of a business.
The name free cash flow derives from the fact that the calculation reveals how much cash is remaining, or “free”, after a business pays for all of its operating and capital expenses. As the name implies, when cash is “free” that means that it is available to fund future growth initiatives, cover debt financing, or pay dividends to shareholders.
This makes it an important metric used by investors to understand how financially stable a business is and how effectively it is managing its capital structure to generate profit. In the same vein, it makes it important for industry professionals as they look to more efficiently manage financial operations and overhead.
How To Calculate Free Cash Flow
There are three different approaches you can take when calculating free cash flow. This is because financial statements are not always uniform, or standardized, across different industries and companies. The three approaches help provide a way to calculate FCF regardless of the type of financial statements being analyzed.
Calculating FCF Using Operating Cash Flow
This is the most commonly applied method of calculating FCF because it is both simple and the information is almost always available in the financial statements. The two items needed to perform the calculation using this methodology are 1) Operating cash flow, located on the Cash Flows Statement, and 2) Capital Expenditures, which are located on the balance sheet.
The formula for calculating FCF using operating cash flow is:
FCF=Cash Flow From Operations – Capital Expenditures
Calculating FCF Using Sales Revenue
In certain cases the cash flow statement might not be available or useful for calculating FCF. In these cases, you can still calculate FCF so long as both the Balance Sheet and Income Statement are available. Calculating FCF using sales revenue is a good option that allows you to reveal FCF by starting with total sales and reducing it by taxes, operating expenses, and the period’s change in operating capital.
Following this methodology is easiest when broken into two separate steps.
Step 1: Calculate the period’s Change in Operating Capital (NOC) using the Balance Sheet.
ΔNOC=NOC – NOCa – NOCb
NOCa is the periods ending Net Operating Capital, and
NOC bis the periods beginning Net Operating Capital, and
NOC = Net Working Capital + Property,Plant,and Equipment (PP&E)
Net Working Capital = Current Assets – Current Liabilities
Step 2: Using the change in operating capital that was calculated in step 1, calculate FCF using total sales, taxes, and operating expenses from the income statement.
FCF = Sales Revenue – Operating Expenses – tax expense – change in net operating capital
Calculating FCF Using Net Operating Profits
This method relies on the calculation of net operating profits after taxes, or NOPAT, and is similar to the previous method in that it uses NOPAT in place of sales revenue.
Using this methodology calculate FCF as follows:
FCF = NOPAT – Change in Operating Capital
NOPAT = Operating Income x (1-effective tax rate), and
Operating Income = Gross Profit – Operating Expenses
It is important to note that this methodology relies on information found on both the balance sheet and in the income statement.
Understanding How To Use Free Cash Flow
Like all financial metrics, analysts use FCF within the context of the business they are investigating. The size, maturity, and industry of a business are all used to help analysts orient themselves with what an appropriate amount free cash flow should be for any given company.
For example, high free cash flow is typically an indicator that the business is running efficiently and is financially stable. However, if the business is small or early in its life, then this could be an indicator that there is liquidity available to fund growth and analysts would expect to see that cash reinvested in the business.
One benefit of using FCF to analyze financial health is that it reveals the stability of the business as a going concern. This helps investors to assign risk to a business as FCF becomes more stable and a business matures.
Using Datarails, a Budgeting and Forecasting Solution
Datarails’ FP&A solution replaces spreadsheets with real-time data and integrates fragmented workbooks and data sources into one centralized location. This allows users to work in the comfort of Microsoft Excel with the support of a much more sophisticated data management system at their disposal.
Every finance department knows how tedious building a budget and forecast can be. Integrating cash flow forecasts with real-time data and up-to-date budgets is a powerful tool that makes forecasting cash easier, more efficient, and shifts the focus to cash analytics.
Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
Datarails is an enhanced data management tool that can help your FP&A team create and monitor cash flow against budgets faster and more accurately than ever before.