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The Significance of Free Cash Flow (FCF) for Businesses

- Guide Authored by Corin B. Arenas, published on September 27, 2019

Planning a new business or expanding a small company? Then you should start managing your finances efficiently, especially your company's free cash flow.

Knowing how to increase free cash flow (FCF) is just as crucial as running smooth business operations. Read on to learn more about FCF, why it's important, and how it impacts businesses.

What is Free Cash Flow?

Free cash flow is money generated by a company after spending on capital assets to maintain and grow its operations.

According to the Wall Street Journal (WSJ), it represents real money that a company has left over each quarter after paying bills and making investments. FCF is income that is available to the company's investors such as lenders, stockholders, and shareholders.

How to Compute Free Cash Flow

To calculate FCF, get the value of operational cash flows from your company's financial statement. This figure is also referred to as ‘operating cash.' Then subtract capital expenditure, which is money required to sustain business operations, from its value. See the formula below:

FCF = Cash from Operations – Capital Expenditure

There are two types of free cash flow:

• Free cash flow to the firm – Also called unlevered FCF. It's the money the business has before paying its financial obligations.
• Free cash flow to equity – Also referred to as levered FCF. It's the amount of cash a business has after it has met its financial obligations.

Examples of financial obligations covered by levered cash flow are operating expenses and interest payments. Analysts use variations of the FCF equation to calculate free cash flow to the firm or equity.

Another way to calculate it is to break down the individual factors that make up cash from operations. This starts with the net income plus depreciation and amortization charges. An adjustment must also be made for the changes in working capital. See the equation below:

FCF = Cash from Operations – Capital Expenditure
FCF = (Net Income + DA – CWC) – Capital Expenditure

• DA stands for depreciation and amortization
• CWC stands for changes in working capital

Depreciation and amortization are added back because FCF must measure money that's spent in the present instead of in previous transactions. This allows investors to recognize profitable companies with high upfront costs. Though it's costly now, it indicates potential for later returns.

Why is Free Cash Flow Important?

FCF is an indicator that gauges the profitability of a business, including expenses like operational costs, equipment, and changes in capital.

It's a more transparent marker that illustrates a company's likelihood to produce cash and profits. While net income also measures profitability, its value factors in taxes and interest.

Having a large amount of FCF enables businesses to expand, streamline operations, and purchase the latest equipment. It also allows companies to engage in short-term investments.

Moreover, companies may reduce debt and pay off investors by allocating free cash flow to dividends.

The Significance of High FCF

FCF directly impacts the value of a company. It is analyzed on a per share basis to assess the effect of dilution, which causes shares to reduce in value.

Dilution is a decrease in a stockholder's ownership percentage of a company. It occurs when a company issues new equity, causing increase in total shares. This makes existing stockholders own a lesser, more diluted percentage of the company.

A high or increasing FCF is a sign of a thriving business. It signifies that a company can grow, buy back shares, and continuously develop new products and services.

Analysts calculate FCF to determine if a company will have enough money to pay back investors (through dividends) after financing its operations. Good FCF also indicates that a company pays monthly dues on time. Essentially, it is considered the credit score of a firm.

Investors look out for companies that show rising free cash flow with undervalued share prices. This disparity usually suggests that a company's share prices and earnings will eventually go up.

FCF suggests whether it's favorable for shareholders to invest in a company, allowing them to select the most profitable firms. Likewise, determining FCF enables companies to choose ventures that would help increase their shareholder value.

Factors That Have the Most Impact on FCF

Net Income

This is the balance in working capital. It influences whether a company can pay monthly bills or pay debt obligations on time. A good net income in your capital account will prevent you from selling business assets or taking out loans, which enable you to avoid debt.

Net income is sales profit minus the cost of the following factors:

• Selling
• Cost of goods sold
• Operating expenses
• General and administrative expenses
• Depreciation
• Taxes
• Interest
• Other expenses

One way to increase net income is to manage the cost of goods sold. For instance, in retail businesses, the cost of goods is normally the biggest expense.

Another way is to decrease selling expenses, which include direct and indirect costs of selling. This means managing costs for wages, sales commissions, advertising and promotions, and travel expenses.

Regularly reviewing expenses helps companies determine if they're overspending or allocating income inefficiently.

Capital Expenditures

Also referred to as CAPEX, it's the investment companies make to run business operations. CAPEX refers to money spent on tangible assets that will be used for more than twelve months.

Depending on the nature of the business, it includes expenses for things like manufacturing equipment, office supplies, delivery vehicles, etc.

Here's formula for calculating CAPEX:

​CAPEX = PPEc ​− PPEp ​+ DE

• PPE stand for plant, property, and equipment
• PPEc​ is the PPE of the current period
• PPEp​ is the PPE of the previous period
• DE stands for depreciation expense​

Money in CAPEX is treated as an asset on the balance sheet. To signify depreciation, it is subtracted over the years, starting from the year after its purchase date.

While CAPEX does not always immediately affect income statements, it affects it in the succeeding years for as long as it is a useful asset.

Basically, higher CAPEX lessens the amount of free cash flow made by companies. But since it's considered an investment, its value improves assets that are crucial for sustaining business operations. 

What Impact Do Recessions Have?

The National Bureau of Economic Research (NBER) describes a recession as ‘a significant decline in economic activity spread across the economy, lasting more than a few months.'

On the other hand, economists define a recession as negative growth in gross domestic product (GDP) due to two consecutive quarters of negative market movement.

Historically, recessions bring about the following economic problems:

• Job loss
• Decline in real income
• Decrease in consumer spending
• Slow manufacturing / industrial production

This means significant decline in sales revenues and profits. The low profits inevitably result in reduced FCF. When recession occurs, companies usually cut back on the following activities:

• Hiring
• Developing new products
• Buying new equipment / supplies
• Advertising and marketing

Cutting costs reduces the quality of goods and services, which creates less profit. Some companies may also reduce package size to lower their cost without impacting perceived pricing.

The company's clients may also make slower payments due to reduced income. Curtailing expenses affects businesses that provide products and services for the company, which results in reduced economic activity.

Moreover, decrease in revenue affects the company's stock value. Dividends also reduce their value, which make it harder to pay back shareholders. If profits keep going down, it will affect the company's ability to maintain operations, pay back debt, and obtain financing.

The Bottom Line

Determining FCF is a transparent way of knowing how much profits a company can generate. If a recession strikes, a significant decrease should be expect for most businesses.

High FCF is a good marker for a thriving business, which means it can expand and develop products and services. It also shows that a company can pay back its investors.

It's an indicator for profitability, which is a good place to start if you're tracking your company's growth.

It certainly makes team building easier!

About the Author

Corin has worked as a health and fitness writer and researcher since 2016. She is interested in longevity research and how to improve the quality of human life. Her other feature articles can be read at Inquirer.net and Manileno.com.