by Mark J. O'Donnell
Free Cash Flow is a common and widely used metric in finance. Free Cash Flow (FCF) is more than just a number; it’s a measure your creditors may use to evaluate your ability to repay borrowing, that potential buyers use to value your business, and, of course, for you to use as a tool to stabilize your business and fund growth.
The information needed for this formula can easily be found in the Statement of Cash Flow in your financial statements. The formula traditional for FCF is:
“Cash from Operations” (the total from the first section of the statement of cash flow) minus “Purchases of Property Plant and Equipment” (one line in the Cash from Investing section).
However, we recommend one change to the traditional FCF formula: subtracting term debt principal repayments (from the Cash from Financing section).
Free Cash Flow = Cash from Operations minus Purchases of Property and equipment and minus payments on term debt
Here are five steps to use the FCF metric effectively each year.
1. Ask your accounting team to prepare an FCF computation for the past five years, including the details from the abovementioned Cash from the Operations section. Since the company’s net income is the starting place for Cash from Operations, we recommend also having a detailed income statement available for these periods.
2. Make a detailed review of that report that will highlight significant variations from year to year; note the underlying reasons, including economic conditions, business growth, unexpected events or expenses, and substantial investments in a particular year.
3. Review those reasons. Some, like the economic conditions, may not be controllable. Other reasons, such as landing (or losing) a significant customer, unusually high accounts receivable, spikes in expenses, large equipment purchases, etc., may be somewhat controllable and require action.
4. Project FCF for the coming months (or year) consistent with company goals and provide an action list for making it happen. Those goals may include investing in marketing to increase sales, opening new locations, designing and introducing new products, reducing debt, building a cash cushion for future years, or maximizing company value (note that prospective buyers frequently use FCF to determine your company value).
5. Review the current year’s FCF before year-end planning. Typically, tax-oriented decisions are made before the company’s year-end to minimize income tax. Most of these decisions require cash or borrowing. Adding FCF year-to-date to that decision process is crucial to balance tax planning with prudent fiscal management.
In summary, this metric is easily determined from already available information, helpful in analyzing past financial results, and valuable for planning. It can impact your business’ economic stability, ability to expand, and value in the event of a sale.
Please send comments, questions, and observations to connectwithus@stcpa.com.
Mark O’Donnell, CPA, is Partner at Schmersahl Treloar & Co. He can be reached at 314.966.2727.