Being an entrepreneur, you wear many different hats - business development hat, customer relationship hat, and more importantly, finance hat.
As the one in charge of all finances, you probably have an approximate idea of what your current profits are in your business. However, you may also have heard of the term “free cash flow”. Is it the same thing? Why should you bother to calculate the FCF of your business?
Keep on reading to find out how to calculate free cash flow and is related to your business and what benefits it brings.
Free Cash Flow - Definition
Free cash flow (FCF) is the cash left over in your company after paying all the operating expenses (the money spent performing your normal business operations) and capital expenditures (the money spent on acquiring or maintaining fixed assets like land or buildings). This cash can be used for business growth, reducing debts, dividends, or other necessary purposes.
The existence of free cash flow is a vital factor which shows that a company has means to expand, buy back stock, develop new products or services, reduce debts or pay dividends. The higher this number is, the better because it is an indicator of a prosperous company which currently advances in its market. Basically, FCF helps establish the real profitability of any business.
Why is it Important to Calculate Your FCF?
If you’re seeking some investments, you should know that investors prefer to invest in small businesses with steady or rising free cash flow because as the company grows, they will be making a return on the investment.
Also, in case you’re planning to get a small business loan to finance new equipment or hire more people to grow your business, have in mind that lenders use free cash flow as an indicator that you’re able to pay back the borrowed funds.
Knowing the exact amount of cash available in your company helps you make wise and informed business decisions. As a business owner, you’re already wearing different hats to ensure that your business runs smoothly. Calculating your free cash flow is just another hat to add to your collection.
How to Calculate Your Free Cash Flow
Let’s take the example of Handmade Shoes. Oscar is a small business owner who manufactures custom-made shoes for various occasions, such as dance shoes, elegant wedding shoes or warm casual boots.
However, Oscar has noticed that he fails to serve all the clients and meet their demands, so he realized that he needs to hire more people in order to deliver excellent customer service and therefore increase his profit. Unfortunately, he doesn’t have enough money for that venture, so Oscar opts for a business loan. But first, he wants to make sure that his business is profitable and able to return the investment, so he decides to calculate the free cash flow of his business.
Oscar earned $100,000 in total revenues, but he had the following expenses:
Salaries: $25,000
Utilities: $4,000
Rent: $10,000
Cost of Goods Sold: $35,000
Interest: $5,000
Taxes: $3,000
Depreciation: $15,000
So, to get net income Oscar subtracted his entire expenses from the total revenue and got $3,000.
Then, to calculate his free cash flow, Oscar added the taxes, depreciation, and interest to the net income. Summing $3,000 + $5,000 + $3,000 + $15,000, he calculated that his FCF equals $26,000.
This calculation showed the amount of earnings Oscar managed to generate to cover his tax payments and interest at the end of the year.
In other words, Oscar’s free cash flow is higher than his capital expenditures, so he is likely to get a business loan because his business is able to pay back the finance funds.
Like Oscar, you can also calculate your free cash flow with four easy steps. With a little bit of simple math, you’ll be able to make an informed decision that will pave the way for new business opportunities.