What is free cash flow?

Very simply put, free cash flow is the cash a business produces that’s truly "free" and available to be used. It is a financial metric that shows the amount of cash a business has on hand after covering expenses and necessary investments. Companies typically use free cash to build up cash reserves, pay off debt, expand operations, invest in new technology or remove money from a business.

The result of a free cash flow calculation is a "positive" or "negative" number. When a business understands whether it has positive or negative free cash flow, it may be easier to confidently know whether it’s time to invest, save or seek financing.

Calculating free cash flow is an important part of cash flow management and provides critical insight for making decisions about business spending, saving and reinvesting.

Why does free cash flow matter?

Unlike profit, which can include numbers that don't reflect cash currently moving in or out of a business, free cash flow shows the actual cash a business has available to spend or save. This fact is why the free cash flow metric is so essential to decision-making and planning.

Here are some of the reasons free cash flow is important:

1. Reveals a businesses' financial health
Free cash flow indicates whether a business generates more money than it needs to cover core expenses and critical investments. Having cash available for growth, unexpected costs or new opportunities signals financial health and is a key business success factor.

2. Shows available cash for business growth
Free cash flow can be used to hire staff, buy equipment, or expand a business in any number of ways. Knowing how much cash is completely available can inform decisions about where to invest in business.

3. May enhance business value
Investors, banks and buyers look at free cash flow to see how strong and healthy your business really is. Strong free cash flow can lead to higher valuations and more favorable deal terms.

It's important to note that negative free cash flow does not always indicate a business issue. For example, a company heavily investing in product development requiring a significant amount of spending may show negative free cash flow, even if it has solid financial health.

Understanding and calculating free cash flow

To calculate free cash flow, a business starts with the cash it brings in from day-to-day operations and then subtracts what it spends on big purchases that help run or grow the business, like equipment, vehicles, property or technology.

Two terms are important for a free cash flow calculation:

• Operating cash flow: The cash a business brings in from selling its products and services, minus the recurring expenses like payroll, rent and inventory it takes to operate.
• Capital expenditures (CapEx): Funds spent on big, long-term costs for things like equipment, vehicles or property.

When you subtract bigger, long-term costs from operating cash flow, which represents cash you bring in minus recurring expenses, you get free cash flow.

Free cash flow formula:

Operating Cash Flow – Capital Expenditures = Free Cash Flow

Here are the steps for calculating free cash flow:

• Find your operating cash flow number. It is on the cash flow statement, usually listed as "net cash from operating activities."
• Subtract capital expenditures. This number is also from a cash flow statement and may be labeled as "capital expenditures" or "purchases of property and equipment."

Free cash flow vs. other key measures

Understanding how free cash flow compares to other important financial metrics can provide insight into your business.

How to improve your businesses' free cash flow

Taking steps to bring cash in more quickly and slow the pace at which it leaves a business may improve free cash flow. Use these tips to adjust cash inflows and outflows.

1. Get paid faster
Encourage faster payments from customers by sending customized invoices to clients and by accepting credit, debit, and electronics payments such as ACH and RTP. Also, consider accepting digital payment through tools such as Zelle. Use mobile check deposits to quickly access funds once you receive them.

2. Manage payment timing
Hold on to business cash as long as possible and avoid late fees with online bill payment tools. Also lean on tools that help you pay quickly such as electronic and digital payments. For larger or international payments, use domestic and international wire transfers to move money speedily and securely. When possible, negotiate longer payment terms with suppliers.

3. Use technology for cash flow management
A cash management system can ease the task of tracking, categorizing and analyzing cash as it moves in and out of a business. Use a cash management system to track and categorize payments so that you can identify which customers are paying slowly and take action. A tool may help gather cash flow insight that can inform decisions, help with forecasting, and reveal where adjustments need to be made to improve cash flow.

Free cash flow: Insight for planning and decision-making

Free cash flow reveals essential, point-in-time information about the cash a business has available for use. This key business financial metric strengthens business decision-making by providing confidence that cash is being put to the best use at the right time. Digital customer payment and bill pay tools may help to optimize the timing of cash coming into and out of a business to bolster free cash. Cash management tools to track and analyze cash flow give insight into what action may be needed to increase the amount of free cash a business can generate to work toward important goals.

Ready to take your business to the next level? Citizens is here to help with cash management solutions to help facilitate cash flow and keep your day-to-day business operations running smoothly.

Cash Management Tools