Nearly 20% of businesses fail within the first year – and 45% fail during the first five years. If you want to ensure that your company isn't one of them, keeping better tabs on your financials is a great place to start.
Free cash flow is one of the most valuable and easy-to-calculate measuring sticks for your company's performance. We'll tell you what that is, why it matters, and how to calculate it in the sections below.
What Is Free Cash Flow? How Do You Calculate It?
Free cash flow is the amount of money your business has left after paying all its operating expenses.
Its formula is straightforward: Free Cash Flow = Operating Cash Flow - Expenditures.
There are other similar formulas that you can use to calculate this if your business isn't keeping track of its operating cash flow. For example, you can use the following:
Free Cash Flow = Sales Revenue - (Operating Costs + Taxes) - Required investments in operating capital
Both formulas return the same value. But the second one may be easier to calculate for some companies.
What's the Value of Calculating Free Cash Flow?
Free cash flow is a metric that every business should be keeping track of. Here are some reasons why this measurement should be part of your analysis as an entrepreneur or small business owner.
Measure Your Company's Efficiency
You can think of free cash flow as a measurement of your company's efficiency. After all your expenses are considered, it tells you how much money you've earned. You can use it to get a good sense of where your business is and whether any profound changes are needed. Free cash flow is a helpful calculation to consider alongside maintaining a thoroughly detailed Profit and Loss and Balance Sheet.
For example, you could bring in six or seven figures in sales revenue. But if your expenses eclipse that total, your business isn't efficient. Even though it generates a lot of sales volume and customer interest, it cannot operate at a price point that rewards that activity.
Early Indication of Potential Trouble
Many companies also use their free cash flow measurement as an early indicator of potential future cash flow shortages.
For example, your company might be profitable historically. But if you suddenly notice that your free cash flow has gone down to harmful levels, you'll know that your cash reserves will start depleting until you fix the problem.
This type of insight can be invaluable. It can help your business adjust course before it begins experiencing significant problems that could threaten its ability to remain open.
Create More Accurate Growth Strategies
Keeping track of your company's free cash flow can also be a growth strategy. If your company is looking to expand, it will need cash to do so. Measuring your free cash flow over an extended period will give you reliable insight into the amount of money you may have for expansion.
It's also worth mentioning here that investors tend to look at free cash flow as one of the metrics you use to evaluate the strength of a company. If your free cash flow is positive, it could be more accessible to onboard new investors or take out a loan if you need more upfront capital to expand the business.
More Profound and More Practical Financial Insight
Keeping track of your company's free cash flow will give you more in-depth and practical insights into your business's performance.
Remember, this can be a measurement of efficiency. So if your cash flow goes towards zero or even negative, it will be a good indication that something needs to change, or you could risk going out of business.
Are There Any Limitations to Free Cash Flow?
As a measurement, free cash flow has a lot going for it. But it's not perfect.
A single measurement of a negative or near-zero free cash flow doesn't necessarily mean that your company is in trouble. Even highly successful companies may dip into this territory from time to time.
That's why it's essential to always look beyond the numbers when calculating free cash flow.
Instead of giving up when you see a wrong number, you should figure out what expenses are dragging your free cash flow down so that you can repair them and resume making progress toward your goals.
The Bottom Line: How Important is Free Cash Flow?
Measuring your free cash flow is a great habit to get into. It's a vital metric that will give you a lot of insight into how your company is doing. Plus, it's relatively easy to calculate – mainly if you use accounting software or automated financial spreadsheets.