# How to Calculate Free Cash Flow

May 08, 2024
AuthorGavin Bales

Welcome to our comprehensive guide on calculating free cash flow. The importance of understanding, calculating, and analyzing free cash flow as an owner, freelancer, or accountant cannot be overstated. It provides valuable insight into how efficiently your business is generating cash and can influence decision making, articulate business potential to investors, and guide future strategies. In this guideline, we will delve into the steps necessary to accurately calculate your company’s free cash flow, unravel the components that make up this financial indicator, and explore its strategic implications. Let’s begin this journey towards better financial decision-making.

## Definition and Importance

Free Cash Flow (FCF) represents the actual amount of cash a company has left from earnings that can be used to invest in itself, pay dividends to shareholders, or pay off debts. It essentially conveys the financial flexibility of the company, which is of crucial importance. As an owner or manager of a small or medium-sized business, a freelancer, or an accountant of these companies, understanding the FCF is vitally important.

This metric provides a clear indication of a company’s profitability and solvency. It directly impacts investment decisions, business expansion strategies, and dividend distribution. For a freelancer, understanding FCF helps in knowing payment potential or dividends to be received if you hold shares in firms. For a business accounting professional, expertise in FCF calculations is key. Not only does it aid in financial analysis or planning for potential investments, but it also helps in evaluating the performance of various departments within the company, thus enabling wiser business decisions for growth and profitability.

## Key Steps or Methods

In calculating free cash flow (FCF), accuracy is a non-negotiable factor. It’s a critical financial health indicator, measuring the cash a company generates after accounting for capital expenditures — a vital metric for investors, suppliers, and internal management. Here, I’ll guide you through six definitive steps to calculate the FCF of a company.

Step 1. Identify Operating Cash Flow (OCF)

Operating cash flow is the total cash obtained from the company’s commercial activities. To find the OCF, review your company’s cash-flow statement. Alternatively, you can deduct operating expenses (excluding depreciation) from your net income and adjust it for changes in working capital.

Step 2. Determine Capital Expenditure (CapEx)

CapEx is the amount spent on major enhancements or acquisition of physical assets such as equipment, properties, or buildings. You can find CapEx in your company’s cash flow statement. It’s usually listed under investing activities as purchases of property, plant, and equipment (PP&E).

## Step 3. Deduct CapEx from OCF

Subtract the CapEx from the OCF. This formula gives you an indication of your company’s financial ability to expand its business without external financing sources. It’s crucial to note that a negative result points to the firm using more CapEx than it is creating in cash flow from its operations, which may not be sustainable in the long run.

Step 4. Calculate Changes in Net Working Capital

Net working capital changes show how much the company’s short-term debt versus assets have changed from the previous period. To find this, subtract the current liabilities from current assets in both the current and prior period, then determine the difference. Add this to your result from Step 3.

## Step 5. Deduct Tax Shield

A tax shield refers to the deduction allowed from taxable income resulting from interest expenses. Deduct this amount from Step 4 result to arrive at your final Free Cash Flow (FCF) figure.

Step 6. Consistently Monitor the FCF

Calculating FCF is not a one-time task. You must do it consistently, ideally quarterly or annually, accurately reflecting the company’s financial health over time. Any significant changes should trigger a deep-dive analysis.

Remember that a positive FCF indicates that after servicing its debt and funding operating activities, the business still has cash leftover. It could use this extra cash for further investment, paying dividends, or reducing debt. So, don’t treat your FCF as a mere financial figure. It’s the backbone of your company’s balance sheet and long-term business decisions, making its accurate calculation a top priority.

## Common Challenges and Solutions

While calculating free cash flow (FCF) is critical for assessing the financial health of a company, it is not without its challenges.

Firstly, understanding and choosing the right inputs can be daunting. One might be unsure about which operating cash flow numbers to input or struggle to identify capital expenditures accurately. Where the information is sourced from can also directly affect the accuracy of the FCF. It’s often beneficial to consult multiple sources, including income statements, cash flow statements, and balance sheets for more reliable data. However, each source would require different information and might present a challenge in discerning which parts to incorporate into the FCF calculation.

An excellent solution to this is to constantly educate oneself about each document. Familiarize yourself with different financial statements and understand how each figure affects the cash flow. This knowledge allows you to interpret the information more accurately to produce a more precise FCF.

Another challenge could be how you interpret the results of your FCF calculations. It can be tricky to understand what a negative or positive FCF means and how it ties into the overall business strategy. The FCF value alone doesn’t provide a comprehensive understanding of a company’s financial position. Therefore, it’s crucial not to rely solely on FCF but to correlate it with other financial metrics.

My advice here would be to pair your FCF calculation with other financial analysis methods. Learn how to use the FCF value to calculate financial ratios or compare it with other companies in the same industry. Such an approach can provide a broader perspective on your company’s financial performance.

In conclusion, calculating FCF comes with challenges such as understanding the right input and interpreting the calculated FCF correctly. However, with constant self-education and coupling FCF with other financial analysis, these challenges can be effectively managed. Remember, understanding cash flow is a journey, so don’t be discouraged if you encounter difficulties along the way.

## Red Flags

When calculating Free Cash Flow (FCF), there are several red flags that you should be aware of. These can help you spot potential issues in your calculations, saving you from making costly mistakes.

First and foremost, consistently negative FCF is a dire warning sign. This could indicate that your business is not generating enough cash to support operations, and could lead to financial distress if not addressed promptly. Frequent ups and downs in FCF could also signify instability, which may deter potential investors.

Maintaining inaccurate or incomplete records is another red flag. Unclear records may lead to miscalculations, and hence incorrect FCF figures. It’s important that you keep detailed and accurate records of all income and expenditure to ensure that your FCF calculations are accurate and up-to-date.

Overreliance on external funding should also raise your eyebrows. If the business continually depends on external sources such as loans and equity financing to generate positive FCF, it signals that the company’s operations are not producing sufficient cash. This circumstance can place the company’s viability at risk in the longer term.

Discrepancies between FCF and Net Income can sometimes indicate creative accounting or manipulation. Net Income is often subject to accounting estimates and policies, while FCF, being a cash-based measure, is more difficult to manipulate. Consequently, substantial discrepancies between these figures should prompt further investigation.

Lastly, if your depreciation and capital expenditure values are consistently misaligned, it could be an alarm to re-evaluate your calculations. If depreciation significantly exceeds capital expenditures on a regular basis, it might indicate underinvestment in maintaining the company’s operational capability.

When calculating FCF, keep these warning signs in mind and investigate any anomalies thoroughly. Remember, understanding your financial status intimately allows you to spot potential issues early and take corrective measures to safeguard the financial health of your enterprise.

## Case Studies or Examples

One perfect example of a practical application of calculating free cash flow (FCF) was the case of a local management consulting firm. This was a small yet fast-growing enterprise, just starting to gain momentum. As their business operations expanded, the complexity of their financial dynamics increased.

The firm was bringing in a pretty decent amount of income, so they thought they were growing positively. However, when they started to calculate their FCF, a different picture began to form. The company’s operating cash flows were indeed high, but when they subtracted their capital expenditures, their FCF turned out to be significantly lower. This was primarily because the firm had been heavily investing in new office equipment and costly marketing efforts. Calculating FCF forced the company to reconsider its unnecessary capital expenditures and revise their financial strategy to maximize free cash flow.

On the other hand, let’s consider a freelance marketing consultant. Income is generally irregular for a freelancer, given the project-based nature of their work. Relying just on revenue figures, it’s easy to get a distorted picture of financial health. In her case, the freelancer began calculating her FCF, considering cash inflow from completed projects and offsetting this against business-related expenses. By doing so, she had a much clearer view of her financial standing, leading to more informed business decisions, like when to launch marketing campaigns and when it’s safe to invest back into her business.

These examples highlight the immense value of understanding and calculating FCF, irrespective of your business size. It reveals the true financial health of your business, helping you make strategic decisions. Remember, revenue might be vanity, profit could be sanity, but cash flow is undoubtedly reality. The reality you’ll only recognize when you start to calculate and understand your FCF.