1. Free cash flow (FCF) represents the money left after operating expenses and capital expenditures, which businesses can use at their discretion.
2. Unlevered FCF reflects cash before financial liabilities; levered FCF shows the cash after liabilities.
3. FCF calculation formula: Operating Cash Flow – Capital Expenditures or Sales Revenue – Operating Expenses – Investments.
4. Positive FCF signals business growth potential, while low FCF indicates a need for improvement.
5. High FCF enables reinvestment and expansion without external financing.
When you are running a business, recording cash inflows and cash outflows properly is important.
After all. cash management plays a vital role in determining what a company is left with at the end of every month, quarter, or financial year.
However, most businesses ignore the free cash flow available to them. This is because they forget how instant these cash alternatives could be during emergencies.
Before exploring what this money means for business growth, let us discover what exactly the term means.
What Is Free Cash Flow (FCF)?
A free cash flow refers to the total amount a company is left with after covering its operating expenses and other costs. This becomes the sum that the firm can use at its own discretion without having to consult anyone as this amount totally belongs to it and is not invest by an investor or any stakeholder. As a result, the companies exercise complete right over the FCF.
Both cash flow and free cash flow might sound similar, but they widely differ.
While the former takes into account the total cash flowing in and out of the business, the latter is the amount of money a company is finally left with after covering the outstanding financial liabilities for a certain period. FCF is the money that businesses are free to use for whatever purpose they want.
Moving further, there are two types of free cash flows that a business might possess – levered and unlevered.
- An unlevered free cash flow is the FCF to the firms. This is the amount that the company has before it deals with the financial liabilities it has.
- A levered free cash flow is the FCF towards equity, which specifies the amount the business is finally left with after taking care of all its financial liabilities.
As a result, it is the levered FCF, which when recorded helps assess how efficiently a business is performing and how much it is saving after meeting all its expenses.
How To Calculate Free Cash Flow?
Calculating the FCF helps businesses get an accurate figure related to how rapidly it’s growing and how far it can expand. Hence, it is important to know the formula to use for correct calculation. The equation used for FCF includes:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
Here,
- Operating cash flow is the cash use to meet operating expenses of the business, which would include both net income and non-cash expenses and consider the change in the net working capital, accordingly adding or subtracting the latter from the former added value (i.e., Net Income + Non-Cash Expenses).
- Capital Expenditures include costs incurred to add, upgrade, or maintain the physical assets that serve to be the foundation of a firm’s production and sales.
In case, companies are unable to figure out the capital expenditure and operating cash flow, they can consider an alternative formula for calculating FCF.
- FCF = Sales revenue – (operating expenses + taxes) – investments required to maintain operating capital
- FCF = Net operating profit after paying all taxes – Net investment in operating capital.
