Free cash flow, also known as FCF, is a ratio for efficiency and liquidity. It helps in calculating the cash of the company and how much they are generating for using it to run as well as expending the business. It subtracts capital expenditure from the company’s business cash flow. It also means how much excess money does the company is generating after paying its CAPEX and operating business. Well, free cash flow is an important measuring ratio as it helps in understanding how well the company is generating its cash. Also, if the company is capable of paying the investors their return after the complete operation as well as expansions.
What More to Know Free Cash Flow?
Well, the ratio is used by the creditors as well as investors is to do the analysing the business in various different ways. With free cash flow, the investors can get a real idea about how the company is actually doing. However, with other financial ratios, there are chances of changes or adjustments by the managements with the treatment of accounting principles. That is not possible when it comes to Free cash flow. It’s hard to show or alter the cash flow coming as well as leaving the company. Because of that, the investors can actually understand the performance and also it provides a return on their investment.
For the creditors, the ratio can be helpful in analysing the company’s cash flow and its ability to fulfil its obligation related to debt.
However, sometimes, excess cash does not mean that the performance of the company is exactly good. Well, it can be possible that the company have a good free cash flow, but they are not investing in buying new equipment and inventories. Not just the company will break down at one point, but also it will slow down the operation work too, whereas negative numbers show that the company is ding investing too much without thinking.
How to Calculate Free Cash Flow and what its Formula with Example?
Measuring cash flow is actually simple; it just calculated how much extra does the company is generating after paying its all expenses and purchase. The calculation can be done with the use of its formula, which looks like this:
Free cash flow = operating cash flow- capital expenditure
For example, the company’s income statement shows that there is a profit of $100,000 after paying taxes last year. More information that were given, depreciation $10,000, amortization was $5000, fixed asset purchases was $50,000, current liabilities was $80,000 and current asset $100,000.
However, the calculation of OCF will be:
$100,000 – ($100,000 – $80,000) + $10,000 + $5,000 = $95,000
To calculate the Free cash flow.
$45,000= $95000 – $50,000
As it can be noticed that the company’s cash flow is greater as compared to its capital expenditure. This means that the company have enough money to pay the creditors and make a decent flow in cash.