What is Free Cash Flow?
Free Cash Flow (FCF) is a financial metric that measures the amount of cash generated by a business’s operations after accounting for necessary capital expenditures. It represents the cash available to the company for discretionary purposes, such as expansion, debt reduction, or dividend payout to shareholders etc.
For example, let’s consider a manufacturing company.
If the company generates $1 million in operating cash inflows and incurs $500,000 in capital expenditures and $200,000 in taxes,
the Free Cash Flow would be $300,000 ($1,000,000 – $500,000 – $200,000).
What is Cash Flow?
Cash Flow refers to the movement of money into and out of a business over a specific period. It includes cash inflows from operating activities (such as sales revenue) and cash outflows from operating, investing, and financing activities (such as expenses, investments, and debt repayments).
Why do you need to know Free Cash Flow in a business?
Knowing Cash Flow is crucial for several reasons:
a) Financial Health Assessment: Free Cash Flow helps assess the financial health and sustainability of a business. It provides insights into the company’s ability to generate cash from operations and fund future growth or repay debt.
b) Investment Decision Making: Free Cash Flow aids in making informed investment decisions. Potential investors or lenders often evaluate a company’s Free Cash Flow to determine its ability to generate returns and meet financial obligations.
c) Strategic Planning: Free Cash Flow is essential for strategic planning. It helps businesses allocate resources effectively, prioritize investments, and identify opportunities for expansion or improvement.
What are the elements of Free Cash Flow (FCF)?
The elements of Free Cash Flow include:
Operating Cash Flow
This represents the cash generated or used in day-to-day business operations, including revenue from sales, minus operating expenses.
Capital Expenditures
These are cash outflows for investments in long-term assets, such as property, plant, and equipment. Capital expenditures are necessary for maintaining or expanding the company’s operations. Buying Inventory for future business plans are also part of this exercise.
Taxes
Free Cash Flow considers the impact of taxes on cash flows. It accounts for cash paid for income taxes, which reduces the available cash.
What is the difference between Free Cash Flow and Cash Flow?
While both Free Cash Flow and Cash Flow involve the movement of money, they focus on different aspects:
Cash Flow: Cash Flow refers to the overall movement of cash into and out of a business, including operating, investing, and financing activities. It represents the total cash inflows and outflows during a specific period.
Free Cash Flow: FCF specifically focuses on the cash available after deducting necessary capital expenditures from operating cash inflows. It represents the discretionary cash that can be used for various purposes, such as expansion, debt reduction, or dividends.
Types of Cash Flow Ratios?
the “Operating Cash Flow” Ratio and the “Cash Flow Coverage Ratio.” Let me explain both of these ratios in detail:
Operating Cash Flow
The Operating Cash Flow Ratio, also known as the Cash Flow from Operations Ratio, is a financial metric that measures a company’s ability to generate cash from its core business operations relative to its current liabilities. It indicates how well a company’s operating cash flow can cover its short-term obligations or current liabilities.
Calculation of Operating Cash Flow Ratio: The formula to calculate the Operating Cash Flow Ratio is as follows:
Operating Cash Flow Ratio = Operating Cash Flow / Current Liabilities
- Operating Cash Flow: Operating Cash Flow represents the cash generated or used by a company’s core business operations during a specific period. It is a key component of a company’s cash flow statement and is calculated as the difference between the net income and adjustments for non-cash expenses and changes in working capital.
Operating Cash Flow = Net Income + Non-cash Expenses (e.g., depreciation, amortization) + Changes in Working Capital + Other Operating Activities
- Current Liabilities: Current Liabilities are the short-term financial obligations that a company needs to settle within the next 12 months. They include items such as accounts payable, short-term loans, and other current liabilities.
Significance of Operating Cash Flow Ratio: The Operating Cash Flow Ratio provides insights into a company’s short-term liquidity and its ability to cover its immediate financial obligations using cash generated from its regular business activities. A higher ratio indicates that a company is generating sufficient cash from its operations to meet its current liabilities, which is a positive sign of financial health and stability.
Cash Flow Coverage Ratio
The Cash Flow Coverage Ratio, also known as the Cash Flow to Debt Ratio, is a financial metric that measures a company’s ability to generate sufficient cash flow to cover its total debt obligations. It assesses the company’s capacity to meet its debt obligations from its operating cash flow.
Calculation of Cash Flow Coverage Ratio: The formula to calculate the Cash Flow Coverage Ratio is as follows:
Cash Flow Coverage Ratio = Operating Cash Flow / Total Debt
- Operating Cash Flow: As mentioned earlier, Operating Cash Flow represents the cash generated from a company’s core business operations.
- Total Debt: Total Debt includes all of a company’s short-term and long-term debt obligations.
Significance of Cash Flow Coverage Ratio: The Cash Flow Coverage Ratio helps investors, creditors, and analysts assess a company’s ability to service its debt using cash generated from its regular operations. A higher ratio indicates that a company is generating enough cash flow to comfortably cover its debt obligations, reducing the risk of default.
Both the Operating Cash Flow and the Cash Flow Coverage Ratios are valuable indicators of a company’s financial health and its ability to meet its short-term and long-term financial obligations using cash generated from its core business activities. These ratios are important tools for investors and analysts in evaluating a company’s cash flow management and overall financial performance.
How to calculate Free Cash Flow (FCF)?
Free Cash Flow can be calculated using the following formula:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
Operating Cash Flow is the cash generated from day-to-day operations, while Capital Expenditures represent the cash outflows for investments in long-term assets.
By understanding and effectively utilizing FCF, businesses can make informed decisions about investments, growth strategies, and financial management.
FAQ on Free Cash Flow
What is free cash flow?
FCF is a financial metric that measures the amount of cash a company generates from its operations after accounting for capital expenditures. It represents the cash available for expansion, debt reduction, or distribution to shareholders.
How is free cash flow calculated?
FCF is calculated by subtracting capital expenditures from the operating cash flow. The formula is: Free Cash Flow = Operating Cash Flow – Capital Expenditures
Why is free cash flow important?
FCF is important for several reasons:
- It provides insights into a company’s financial health and its ability to fund future growth.
- Investors use FCF to assess the company’s profitability and evaluate potential returns.
- It helps determine a company’s capacity to pay dividends or reduce debt.
What is the difference between FCF and Net Cash flow?
Net Cash Flow refers to the total inflows and outflows of cash during a specific period, including operating, investing, and financing activities.
FCF, on the other hand, focuses specifically on the cash generated from operations after deducting capital expenditures.
How does FCF differ from profit?
Profit represents the surplus revenue a company earns after deducting expenses. FCF, however, takes into account not only profits but also the impact of capital expenditures on the company’s cash position.
What does a positive FCF indicate?
A positive FCF indicates that a company is generating more cash from its operations than it is spending on capital expenditures. It suggests the company has the potential to invest in growth opportunities, repay debt, or distribute dividends.
Can free cash flow be negative?
Yes, FCF can be negative if a company’s capital expenditures exceed its operating cash flow. It could indicate that the company is investing heavily in its operations, which may be necessary for long-term growth but may result in short-term negative cash flow.
How can a company improve its FCF?
Companies can improve their FCF by:
- Increasing operating cash flow through higher sales or more efficient operations.
- Managing and reducing unnecessary capital expenditures.
- Optimizing working capital management, such as managing inventory levels and improving collections from customers.
How is FCF used in financial analysis?
FCF is widely used in financial analysis as a measure of a company’s financial performance and its ability to generate cash. It helps evaluate investment opportunities, assess the company’s ability to meet financial obligations, and determine its value.
How can ACTouch Cloud ERP Software help in managing FCF?
ACTouch Cloud ERP Software provides comprehensive financial management features, including cash flow tracking and analysis. It enables businesses to monitor and manage their cash flow effectively, make informed financial decisions, and optimise FCF.