Understanding Free Cash Flow
It’s a great metric for investors, managers, and creditors.
‘Never take your eyes off the cash flow because it’s the lifeblood of business.’ Richard Branson
Free cash flow (FCF) is my mostest favouritest metric for businesses of all sizes.
It represents the cash remaining after covering all operational and capital expenses. In simplest terms, think of it as the money you have left over after covering all your operating expenses.
You use it to reinvest in your business, pay dividends, or reduce debt.
What is free cash flow
Free cash flow is the cash generated by a business’s operations after accounting for both operating expenses (OpEx) and capital expenditures (CapEx). It’s the actual cash available after meeting your business’s day-to-day running costs and essential investments.
Here’s the formula for calculating free cash flow. It’s way simple:
Unpack that formula:
FCF: Free cash flow. This is a Good Thing.
NOPAT: Net operating profit after tax. This is what’s left over from gross profit after accounting for taxes, operating expenses, depreciation and amortisation.
CapEx: These are the expenses of acquiring or upgrading long-term assets. Things like property, equipment, and your dad’s Tesla.
Why free cash flow matters
Free cash flow is like a window into your business’s financial health and future prospects. Stakeholders love it too, because when you show good FCF they know you have your finger on the pulse:
For investors
Financial Strength: A positive FCF proves your business’s ability to generate cash and reinvest it for growth or to return it to shareholders through dividends.
Long-Term Viability: A positive FCF says your business can sustain its operations and potentially weather financial storms.
Valuation Tool: A positive FCF proves a company’s intrinsic value> great for when you’re in front of your bank asking for a loan, and even better when you’re selling your business. The future owners will be impressed.
For managers
Financial Efficiency: Diving into the FCF calculation helps identify problem areas (think cost reduction and operational improvement), and the parts of your business that shine.
Capital Allocation: Understand which areas contribute to FCF so you know where to invest and where to allocate resources.
Performance Evaluation: Track FCF over time to catch trends early and quantify the success (or otherwise) of your strategic and operating plans.
For creditors
Debt Repayment Capacity: A strong FCF indicates your business’s ability to pay debt on time and proves reduced risk for lenders.
Financial Stability: A consistent FCF stream reassures creditors of your business’s financial stability and strengthens your borrowing capacity (side note - so does paying your invoices on time, just saying).
Risk Assessment: FCF helps potential creditors (like banks and private equity) assess the financial health of your business and make happy lending or investment decisions.
Finding free cash flow
Here are some ways to increase FCF:
Boost Revenue: Basically, sell more. This means expanding your customer base, introducing new products or services, or increasing prices. Or all three.
Optimise Costs: Look over your expenses and find areas you can cut back without compromising quality or operations.
Get Paid. Keep on top of your accounts receivable. If there’s money due, get on the phone and collect it. Way better in your account than your customer’s.
Improve Inventory Management: Minimise inventory levels to reduce storage costs and tied-up capital. This one is huge.
Negotiate Better Payment Terms: Negotiate longer payment terms with suppliers.
Offer Early Payment Discounts: Incentivise customers to pay early by offering discounts, leading to quicker cash inflow.
Lease Instead of Buy: Leasing assets instead of purchasing outright reduces upfront costs and improves FCF in the short term.
A metric that matters
Free cash flow is a great metric for understanding a company’s financial health and performance. By managing for improved FCF, your business unlocks opportunities for growth, investment, and debt repayment. All good things.
