Free cash flow is simply the measure of funds moving in and out of a particular company’s bank account during a specified period of time. Free cash flow, also called net income, is the money left over after the business has paid all of its expenses and overhead (capital expenditures and interest on the debt). Cash generated from operations is termed primary cash, and that money plus expenses are referred to as secondary cache. The difference between primary and secondary cache is referred to as the funding gap.
To better understand free cash flow and its importance to an enterprise, it’s helpful to break down the financial statement so that we can better understand what occurs throughout the year. Companies use several methods to measure their operating cash flow including gross selling, gross revenue, cost of goods sold, factory overheads, and other costs. A company can best use its cash flows by considering its best practices as far as determining how much to invest in equipment and facility improvements, which impact gross profit and operating cash flow.
As an example, consider two companies, A and B, that have both made their initial public offerings (IPOs). At the beginning of each company’s first full year of operation, A’s free cash flow statement will show a positive cash position. By the end of the second year, however, A’s gross profit has dropped to zero, due to lower revenue. Likewise, in order for B to raise its equity, it must realize an increase in its investment in equity. In this scenario, there are financing activities needed to close this gap.
The primary function of the company’s finance department is to manage a positive free cash flow number. To achieve this result, they need to accumulate enough positive free cash flow dollars over the course of the year. However, it is also important for them to realize that they must continually reduce expenses to generate an increasing amount of positive cash from operations. The most common way to do this is to reduce expenses related to marketing, in addition to property and equipment maintenance. Relying solely on retained revenue to meet these expenses creates a negative free cash flow number.
When assessing expenses to calculate a cash flow statement, the simplest method is to add all expenditures, including rent or mortgage, inventory, and supplies, to the current balance. The current balance is then divided by revenues to arrive at an expense ratio, which is a ratio of expenses to revenues. This ratio indicates the percentage of revenue that is spent on overhead versus revenue. Lower numbers indicate increased operating overhead costs, while higher numbers indicate reduced profitability.
A company’s balance sheet, which includes its accounts receivable and accounts payable, represents its sources of liquidity, which come from several sources. Among these sources are the sales of products or services, the provision of assets, and investments in fixed assets. While the majority of revenue accrues to the sales of goods or services, the balance sheet must also indicate the sources from which the remaining portion, known as the non-revenue items, is generated. These items are usually purchased from suppliers and returned to the business when paid. Examples of non-revenue items include depreciated or obsolete inventory, accounts payable, and professional service charges.
To calculate the free cash flow statement, start with the balance sheet and deduct the cost of capital from the equity basis of the company. The difference between the equity and cost of capital is called net worth. Subtract the net worth from the current cash flow position to arrive at an income statement. The income statement should be corrected for current and long-term debt, if available.
Once the income statement is calculated, the net worth of the business can be re-examined to determine the net cash flows. The net cash flows should be greater than or equal to the revenue figure from the previous step. If the net income or net cash flows are less than the revenue, additional financing may be required. For this purpose, financial managers refer to a bank overdraft facility, the terms of which will be described later in this article.