Profitability is essential for a business, but profitability alone doesn't reflect a company's ability to generate and manage cash. Understanding the metrics that give you an overview of your business' financial health is crucial for making informed decisions.
Traditional financial metrics, like revenue and profit, don’t provide a complete picture of a company's financial strength; but calculating Free Cash Flow (FCF) can help a company assess its ability to generate cash and its potential for future growth. Analyzing FCF provides businesses with a deeper understanding of financial performance and allows them to evaluate long-term sustainability.
In this article, we’ll delve into the concept of FCF; what it is, why it’s significant in financial planning, and how to accurately use formulas for calculation.
What is FCF?
At its core, FCF represents the cash that remains after a company has paid for its operating expenses and capital expenditures (investments in long-term assets).
One of the key advantages of FCF is that it provides insights into the amount of cash available for distribution, reinvestment, or debt repayment. As a key indicator of a company's financial health and sustainability, investors and analysts can assess whether a company has a healthy cash position to meet its financial obligations, invest in growth opportunities, or return cash to shareholders in the form of dividends or share buybacks. In other words, by utilizing FCF in your cash flow analysis, you can gain a more accurate and reliable understanding of financial performance.
Before calculating FCF, it's essential to understand its key components:
Operating Cash Flow
Operating Cash Flow (OCF) is the cash generated or used by a company's core operations. It represents the cash flow from day-to-day activities, such as sales revenue, cost of goods sold, salaries, taxes, and other operating expenses.
For instance, a manufacturing company's OCF would include the cash received from customers for products sold, minus the cash paid for raw materials, wages, utilities, and other operating expenses. OCF is typically reported in the cash flow statement of a company's financial statements.
Capital Expenditures (CapEx) are investments made by a company in long-term assets, such as property, plant, and equipment (PP&E), to support its operations and future growth. CapEx includes expenditures on new buildings, machinery, technology upgrades, and other tangible assets.
For instance, if a retail company plans to open new stores or upgrade its existing infrastructure, the cash spent on purchasing or improving store locations, renovating facilities, and acquiring new equipment would be considered CapEx. This is usually reported in the balance sheet or cash flow statement.
When calculating FCF, These components provide a better understanding of how a company generates and utilizes its cash resources.
How to Calculate FCF
There are three methods that provide different perspectives when calculating FCF: OCF, sales revenue, and net operating profits.
This is a widely used approach to calculate FCF, because it’s easy and readily available and it focuses on the cash flows generated by a company's core operations. This is the formula for calculating FCF using this method:
FCF = OCF - CapEx
By subtracting CapEx from OCF, the calculation of FCF takes into account the cash required for maintaining and enhancing the company's productive capacity. This enables investors to assess the level of reinvestment in the business and the company's commitment to long-term growth.
For example, if a company has a positive OCF of $1,000,000 and capital expenditures of $300,000, the calculation of FCF using the operating cash flow method would be $700,000.
This scenario is an example of a positive FCF, which suggests the company has generated more cash from its operations than it has spent on CapEx; the result is available excess cash for necessary investments in long-term assets. On the other hand, a negative FCF indicates that the cash generated is insufficient to cover the company's CapEx. In other words, the company is spending more on investments in long-term assets than it’s generating from its core operations.
Using Sales Revenue
Calculating FCF using sales revenue involves subtracting the costs associated with generating that revenue from the total sales revenue. This method utilizes information from the income statement and balance sheet to evaluate the cash flow generated by the company's business activities after considering expenses and investments in operating capital.
The formula for calculating FCF using the sales revenue method is as follows:
FCF = Sales Revenue - (Operating Costs + Taxes) - Required Investments in Operating Capital
The sales revenue figure, located on the income statement, represents the total amount generated by the company through its sales activities. Subsequently, to calculate FCF, the costs associated with generating that revenue are subtracted from the total sales revenue.
These costs typically include operating expenses, like cost of goods sold (COGS) and selling, general, and administrative costs (SG&A). By deducting these costs, the calculation accounts for the direct expenses incurred in the process of generating revenue. Moreover, taxes represent an important financial obligation and are also deducted from the total sales revenue.
The required investments in operating capital, also known as the net investment in operating capital, are subtracted from the previous result. This component, derived from the balance sheet, captures the changes in the company's investment in operating assets and liabilities over time. It reflects the cash flows associated with working capital items, such as accounts receivable, accounts payable, inventory, and other operational assets and liabilities.
Using this method, stakeholders can assess the cash flow generated by the company's sales activities after accounting for operating costs, taxes, and the required investments in operating capital.
Net Operating Profits Method
The Net Operating Profits After Taxes (NOPATs) method is another alternative approach with two components: Net Investment in Operating Capital and Net Operating Profit After Taxes.
NOPAT is the profit generated by a company's operations after deducting taxes. It measures the company's profitability from its core operations, taking into account the impact of taxes. On the other hand, Net Investment in Operating Capital reflects the changes in the company's cash tied up in the day-to-day operations of the business.
Using this method, the formula for calculating FCF is as follows:
FCF = NOPAT - Net Investment in Operating Capital
Calculating FCF using NOPAT provides insights into the cash generated by the company's operations after accounting for taxes and the impact of changes in operating capital. It also helps assess the cash flow available for distribution to investors, debt repayment, or reinvestment in the business.
How FCF Varies from Net Income & EBITDA
When compared to other financial metrics, FCF is a more robust measure, as it excludes certain non-cash items like depreciation and amortization from its calculation. Additionally, FCF disregards changes in inventory values and stock-based employee compensation, focusing solely on cash transactions. The exclusion of non-cash items allows FCF to provide a clearer and more accurate picture of a company's actual profitability and cash-generating ability.
By focusing on cash transactions, FCF can reveal the true, underlying profitability of the company and mitigate the effects of these accounting maneuvers. Furthermore, if a company has made significant purchases, such as acquiring a new property or investing in intangible assets, these expenditures could impact net earnings but not necessarily affect FCF. In such cases, FCF might be higher than net income, or it could remain positive even if the company reports a net loss.
FCF differs from earnings before interest, taxes, depreciation, and amortization (EBITDA) in that EBITDA excludes both interest payments on debt and tax payments. Both FCF and EBITDA help to reveal a company's true cash-generating potential, but they focus on different aspects. EBITDA is particularly useful for comparing a company's profit potential to its peers and evaluating operational efficiency.
Why FCF is Crucial in Financial Planning & Analysis
Through FCF, FP&A professionals can finance strategically, allocate resources optimally, and contribute to the company's long-term financial success. Here's why you should calculate FCF:
- Assessing Financial Health: FCF provides a clear measure of a company's cash-generating ability after accounting for all expenses and investments. It allows FP&A professionals to evaluate the company's financial health, liquidity, and ability to meet its financial obligations.
- Forecasting Cash Flow: FP&A teams use historical FCF data to forecast future cash flows. These projections enable them to anticipate potential cash shortfalls or surpluses, plan for CapEx, and develop strategies to optimize cash flow management.
- Investment and Growth Decisions: FCF helps in assessing the financial feasibility of investment projects and growth opportunities. Businesses can analyze how much cash the company can generate internally to fund expansions or acquisitions, reducing reliance on external financing and minimizing financial risk.
- Capital Allocation: Understanding FCF facilitates informed decisions about whether excess cash should be allocated to debt repayment, dividend payments to shareholders, stock buybacks, or reinvestment in the business.
- Identifying Operational Efficiency: By analyzing FCF alongside operational metrics, businesses can pinpoint areas of inefficiency in the company's operations. For example, if FCF remains consistently lower than expected based on revenues and operating expenses, it may indicate inefficiencies in working capital management or CapEx.
- Valuation and Performance Analysis: FCF is a critical metric for valuing companies and comparing their performance. In discounted cash flow (DCF) valuations, FCF is used to estimate the company's intrinsic value. In performance analysis, FCF provides a more accurate measure of profitability and cash generation than net income or EBITDA.
- Risk Management: Monitoring FCF helps identify potential financial risks and ensures the company can maintain adequate liquidity to weather economic downturns or unforeseen events.
Understanding and optimizing FCF is vital for effective financial planning and decision-making, because it helps in assessing the feasibility of investment projects, identifying areas of operational inefficiency, and guiding capital allocation strategies.
Unlike other financial metrics, FCF provides a more accurate and comprehensive measure of a company's intrinsic worth and financial nuances that might distort its actual profitability.
With Jirav's advanced features, you can effortlessly analyze cash flow dynamics to make well-informed financial decisions. Jirav empowers you with the right insights to drive your company's financial success with confidence. Book a demo with our team of experts to customize the solution that will support your business in growth and financial success.