29 Jan 2025
This term might sound intimidating but Free Cash Flow is one of the best metrics to know about in the world of finance. It doesn’t matter if you are an investor, running a business, or simply a person trying to make good financial decisions that yield positive outcomes; knowing and understanding free cash flow and how it works is crucial. Even a simple decision, such as an online money transfer to someone as payment, requires background knowledge of FCF.
Don’t worry. This blog will explain all the basics and the benefits of free cash flow so that you can use this tool for your financial decisions.
Understanding free cash flow is essential. When you start doing your business, you will get a certain amount of cash inflow due to business operations. This money is then used for different expenses, such as capital expenditure, which is crucial to keep your business running. The money that’s left after you’ve accounted for your capital expenditure is the free cash flow.
Now, this money is to be used for varying purposes. You could either distribute it as profit between your shareholders or repay your debt with it. You could also reinvest that money in something else, like another business. There are many options, such as how financial health and FCF are related. The question is how will you use that cash inflow. Let’s look at the basic formula for free cash flow:
FCF (Free Cash Flow) = Operating Cash Flow – Capital Expenditures
Your operating cash flow is the cash that comes from doing your business, such as the money you earn from selling your product or service. Capital expenditure or CapEx is the cash you use to buy new or upgrade your existing business assets such as a vehicle, a building, land, or equipment.
When you exclude that capital expenditure from your total operating cash flow, you will see a clearer picture of just how healthy your business is in financial terms. This is one of the free cash flow benefits. Now let's look at why understanding free cash flow is so important:
Why is FCF so important for business success? Several factors can answer that question. Below is a breakdown of some of the benefits that free cash flow has to offer:
If you have read what FCF means, you probably know why it could be a good indicator of a business’s financial health. This metric is straightforward in measuring how much cash is left after operational expenses are met.
If the FCF is positive, it shows that the business can sustain itself and has the potential to grow. If it is negative, it shows that the business is barely hanging on in financial terms and could tip over at any point. So, it is a good idea to look for ways of improving free cash flow.
Cash flow analysis for businesses is essential. Logically, if you have a pretty good positive FCF, you have a higher chance of reinvesting the money into your business and growing it. The FCF could fund the research and Development department, enter new markets, or buy other companies. Consider FCF as a fuel to catalyze innovation and business growth.
Now, if you are viewing FCF from the perspective of an investor, it serves as an essential measure for making financial decisions. Essentially, you must be trying to answer one question before you send money to invest in a business: Is this business worth investing my money in or not? So, while looking at the business’s financial statements and ratios, you should be looking for its FCF figure because financial health and FCF go hand in hand.
A healthy FCF indicates that the company has the capability to offer returns to its investors in the form of dividends. It also shows that the company isn’t at risk of defaulting on debt. An indicator like FCF can tell you a lot of valuable things to help you make an informed financial decision.
Here’s how a cash flow analysis for businesses works: As a business, you must know that keeping a healthy FCF will always benefit you. When things get shaky such as in the case of an economic downturn, your FCF will act as a buffer zone to reduce the damage reaching your business. FCF offers liquidity which is needed to pay back debt, cover operating expenses and adapt to any changes in the market.
If you don’t have a healthy positive FCF, you will need to look for external financing avenues that will allow you to get more loans or dilute equity by issuing more shares.
There are tons of methods through which a business’s financial picture is analyzed including the usage of valuation models like the Discounted Cash Flow (DCF) analysis. Don’t get scared of the big word. It is just a projection of the future free cash flows of a business that are discounted back to their present value.
One of the free cash flow benefits is that it helps analysts measure the worth of a business in practical terms.
Now that we have seen how important FCF can be for individuals, businesses, and investors, the next step is to see how to use FCF for business success:
The purpose is to look for patterns. See what figures of FCF your business has gotten over the years. Now check if it has remained pretty much the same over the years or if has it been growing or declining. If your FCF has remained steady at a positive figure, it probably means your business is doing okay. If it has been increasing, that’s even better but if it has been declining, then that could be alarming. It warrants an investigation into what’s going wrong.
Different industries have different thresholds for capital requirements. Identify the industry your business belongs to and see what the average FCF figure is for the industry. The next step is to compare it to your own company’s FCF and see if you are above, below, or on average levels. This is because financial health and FCF are closely related.
Let’s look at the two figures needed to calculate the FCF, i.e., operating cash flow and capital expenditures. Compare the two figures and see if the capital expenditure figure is high compared to your operating cash flow. If that is the case, it indicates low liquidity levels for your business.
The next step in understanding free cash flow would be to see why the capital expenditure is so high. If it results in generating returns then perhaps that is okay but if it is choking cash flow, you have a problem.
For cash flow analysis for businesses, try this new kind of measure derived from FCF. To calculate it you have to first calculate FCF per share by dividing the total FCF by the total number of shares. Then you take that figure and divide it by the stock price. That is your FCF yield. It is a very useful measure for investors who want to decide whether to invest in a company or not.
FCF yield shows how much cash flow is generated in comparison to a company’s market value, and it tells you whether improving free cash flow is required.
A free cash flow ratio identifies how good a business is in generating cash in relation to its obligations. It basically shows whether the company has enough cash to pay its liabilities. To calculate it, you need to divide your free cash flow figure by operating cash flow. The higher the ratio figure, the better for the company.
Free cash flow benefits include the fact that it can indicate a lot of essential pieces of information for individuals, investors, and businesses, but it is not without its limitations. There are certain things that make it not too perfect:
Depending on the type of business you run, there can be frequent fluctuations in your capital expenditures which will then cause frequent fluctuations in your FCF. It may look like the free cash flow figures are volatile and therefore the business might be going through a rough phase but that would be a wrong interpretation in this case. When using FCF for business success, you have to be cautious about it.
Sometimes if a company is too focused on keeping a positive FCF, it can easily overlook investment opportunities for the growth of the business. This is short-term benefit and it will harm the business in the long run, risking stagnation. So keep in view other factors besides FCF figures to maintain a balanced interpretation before planning a long-term strategy.
Every company chooses a certain type of accounting practice for its accounting which can impact how FCF is calculated and subsequently make comparison difficult. Understanding this is part of understanding free cash flow and how it works.
Just like any other metric, FCF can be beneficial if it is used the right way. Overreliance on free cash flow benefits might lead to bad financial decisions so it is important to understand both its purpose and limitations. This way you can monitor, evaluate and plan all transactions such as a money transfer to a supplier. FCF can show you your financial ratios and figures in a new light for you to make better and informed financial strategies.
Free Cash Flow is important for investors because it reveals how much cash a company has available to return to shareholders, reinvest in growth, or pay down debt. It’s a reliable measure of financial health and long-term sustainability.
Net Income is a company’s profit after all expenses, while Free Cash Flow focuses on actual cash generated after operational and capital costs. FCF provides a clearer view of liquidity than net income.
Yes, a company can have negative FCF if its capital expenditures exceed its operating cash flow. This is common for growing companies investing heavily in expansion.
FCF directly impacts a company’s ability to pay dividends. Companies with strong and consistent FCFs are more likely to sustain or increase dividend payouts.
No, while FCF is a valuable metric, it’s essential to use it alongside other financial metrics like earnings, revenue growth, and debt levels to get a comprehensive view of a company’s performance.
