Importance of Free Cash Flow

In some previous posting I discussed how important it was to convert profits to cash. See Cash Flow – The Bottom Line for more on this. Now let’s look at cash from a different perspective.

Free Cash Flow Defined

Generally free cash flow is considered to be operating cash flow minus capital expenditures. This recognizes that capital spending for things like equipment is necessary if a company is to remain competitive. These capital expenditures help a company become more efficient or even allow them to expand into other markets, products and services.

How to Calculate Free Cash Flow

Free Cash Flow = Operating Cash Flow – Capital Expenditures

Of course, to understand this you need to know that operating cash flow is the cash produced during the normal course of operating a business. It is net income adjusted for several items, such as changes in accounts receivable, inventory, accounts payable, etc. Those items are too numerous to list here, but the point is that these adjustments are necessary to derive the actual operating cash flow. For example, suppose a company has sales of $10 million and a net profit of $2 million. If in achieving this profit the company saw its accounts receivable climb from $1 million to $2 million, the increase in accounts receivable of $1 million must be excluded from the net income to arrive at the operating cash flow. Again, the change in accounts receivable is just one of the adjustments needed to net profit to arrive at operating cash flow.

So Why Does Free Cash Flow Matter

Let’s consider the scenario above where a company had a net profit of $2 million. After adjusting for things like changes in accounts receivable, accounts payable, etc.., the operating cash flow is calculated as $750,000. If the company made capital expenditures of $500,000 then the calculation for free cash flow is:

Free Cash Flow = Operating Cash Flow – Capital Expenditures

Free Cash Flow = $750.000 – $500,000 = $250,000

In this case the free cash flow is $1,750,000 less than the net profit and $500,000 less than the operating cash flow. This remaining $250,000 in free cash flow represents cash available for such things as expansion. This is the money that is available to reinvest in the business to grow it.

Now suppose that the capital expenditures had been $750,000, In that case the free cash flow would be $0 and leave no cash for growing the business.

Measure It and Track It

It is important to measure and track both the operating cash flow and the free cash flow. The first one is an indicator of how successful your company is from an operational standpoint while the second one is indicative of how much ability the company has to expand.

Do you understand these measurements and their importance? If not, I encourage you to get familiar with them.

If you want to know more, contact AimCFO – Contact

As always, your comments are welcomed.

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