How to Calculate Free Cash Flow (And Why You Should)
For many small businesses, cash flow statements are an afterthought (if they are even generated). But cash that translates into dollar bills matters way more than EBITDA or some other financial metric, because it’s the money you can actually use – whether in the business or elsewhere. A business’s ability to turn earnings into cash flow determines how much that business is worth.
What is a Cash Flow Statement?
You’re already reviewing your balance sheet and your profit and loss statement every year – what’s a cash flow statement going to tell you that you’re not already getting?
Ultimately, your cash flow statement tells you how efficient you are at turning earnings into real dollars. That’s important because those dollars allow you either to reinvest in your business and grow or to make distributions to your shareholders. It’s what your business actually made. In essence, it’s the amount of earnings that stuck to you – what we consider earnings quality.
In smaller businesses, this sometimes gets lost in the shuffle because the CEO or the owner is the shareholder, so they don’t necessarily see the difference between making money and turning it into cash or aren’t able to differentiate between what they are reinvesting in the business to grow and what is being reinvested to just stay in the same place. Their net worth is tied up in the business regardless. But, at the end of the day, the number of dollars that you’re able to distribute or reinvest in growth determines your total long-term return on that equity. The higher the potential returns, the more valuable your business.
If you’re an illiquid small business and you’re not selling your business, the overall enterprise value of your business may not matter day-to-day. Until it does.
When you go to market, cash flow matters. If you partner with a private equity firm like Permanent Equity, with shareholders and an expectation for returns, the ability to distribute dollars out of the business and/or consciously reinvest free cash flow and measure its return in addition to showing earnings becomes critical.
How Do You Get One?
While you can ask your accountant to prepare a cash flow statement for you, it’s also worth knowing what goes into it.
If you’ve got an income statement, a beginning balance sheet, and a year-end balance sheet, you can generate a cash flow statement. At heart, a cash flow statement reconciles the amount of money you made on the income statement to the amount of actual cash you put on the balance sheet. To figure out how much cash you’ve generated:
Free cash flow = net profit + non-cash expenses - capital expenditures - change in working capital
Technically, this calculates structural free cash flow – there are many other non-cash or cash movements that can swing total free cash flow, but they tend to be smaller and not impact projections. A nuance here is that there are different flavors of capex and working capital. If you are able to differentiate between maintenance (what it takes to keep the business in the same place) and growth (what it takes to change the trajectory of the business for the better), you will want to call that out. Your business may actually generate lots of free cash flow if it isn’t growing, but growing is another way of creating value alongside distributions.
Now What?
Cash flow statements aren’t only useful for determining the value of your business when considering selling or bringing on a partner – it can provide key insights into how efficient your business is.
Take your free cash flow and divide it by your P&L earnings over the same period. If your free cash flow is less than 75% of your reported earnings and you’re not growing, your business is inefficient. You’re losing opportunities to turn earnings into cash flow and, ultimately, cash flow into distributable or reinvestable cash flow. And, you’ll want to know why.
It could be under 75% because your receivables went up. That means that your customers aren’t paying you in a timely manner, effectively using you as an interest-free loan. Or it could be under 75% because you’re making a lot of capex investments. If that’s the case, you need to know if you’re making a return on those investments. Is it maintenance capex or growth capex? Are those investments growing capacity or not? If you’re spending $500,000 a year to have the same amount of earnings or those earnings aren’t going up more than inflation, that’s maintenance. These types of considerations help you understand how asset-intensive your organization is and how you’re financing necessary capital expenditures.
This 75% watermark is also important if you’re selling your business or looking for investment. If your free cash flow is under this mark, expect a lot of questions about why. There are legitimate reasons it might be the case (for example, you invested a lot of money into growth capex or you’re keeping capital on the balance sheet as a buffer against a downturn). But, recognize that if you’re retaining earnings because you want to invest in your business or for peace of mind, you’re making a very deliberate choice.
If you invested in a lot of inventory and made the same amount of money, your return on assets went down. It was harder for you to make the same amount of money. Which means that your business is worth less. If you go to market making $5 million on $5 million in assets, your business is better than one $5 million on $100 million in assets – it scales better, it’s more profitable, and it’s able to distribute more cash to ownership.
Knowing (and tracking) your free cash flow tells you a lot about your business. Monitor the proportion of earnings that turns into free cash flow over time. If it’s not 90-100%, make sure you know why.
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