In order to continue to operate successfully, all businesses will need to be able to earn a positive income. One of the biggest tests that a business will have is whether it is cash flow positive and has free cash flow. So, it’s important to know how to calculate free cash flow.
This article will explain what free cash flow is, and how to determine it. You can also see how a business can increase its free cash flow, and what a business should do with the excess cash flow that it earns.
What Is Free Cash Flow?
Free cash flow is one of the most important financial metrics for a business or any organization. Free cash flow means how much extra money you have at the end of a certain period of time.
It is ultimately the amount of money that your business has earned. Moreover, it should be equal to an increase in the amount of cash that your business has on its balance sheet at the end of any given period of time.
How to Calculate Free Cash Flow
Due to the importance of free cash flow, all business owners need to know how to calculate free cash flow correctly. Also, due to the complexity of many businesses, this can seem hard. But it can be broken easily to be calculated.
- When you are wondering how to calculate free cash flow, the first thing that you need are your net sales. Net sales should be your gross revenue for any given period minus your costs of goods sold. If you do not require payment up front from your customers, you will also need to consider the costs of bad debt. This can range anywhere from 1-5% of total sales depending on your business and customer profile.
- After figuring out net sales, the next step in how to calculate free cash flow is to determine your costs. All regular operating and capital costs and expenses should be there, which can include supply costs, employee costs, benefits, and rent. You will then need to back out all of your capital costs. These can include your interest on a loan, mortgage payment, building rent, and equipment leases.
- After backing out operating and capital costs, you will next be left with taxable income. To determine your free cash flow, you will have to make an estimate for your taxes. These should be around 35% of net income to be conservative.
- Finally, you will need to back out any costs associated with capital purchases and investments that you made during the period.
How to Increase Free Cash Flow
Once you have figured out how to calculate free cash flow, the next step would be to determine how you can increase it. There are a number of different things that you can do to increase your free cash flow.
- The first would be to increase profitable sales. Increasing revenue should have a direct impact on your bottom line, if you go about it the right way. However, you will need to make sure that each sale that is made is profitable and active. To do this, you need to make sure that you are selling your product or service for an amount high enough to comfortably cover the costs of production, commissions, and other related expenses. Some great ways to increase your sales would be to spend more time marketing, hire inside or outside sales people, or unveil a new product or service.
- Another tip that you can follow to increase your free cash flow would be to reduce your production and operating costs. There are a number of things that you could do to cut costs. These include negotiating lower rates with your vendors. You can also find ways to increase efficiency in your place of business and production process, or do your best to minimize overtime and other labor costs.
- The third way to reduce your free cash flow would be to reduce your capital costs. Some ways to reduce capital costs would include negotiating a lower interest rate on your loan, finding a more affordable place to operate your business, or simply by paying down debt.
What to Do with Free Cash Flow
Once you have determined how to calculate free cash flow and figured out how to increase free cash flow, the next step is to figure out what you should do with it. If you have excess free cash flow in your business, you will have a number of great options of what to do with it.
- The first option would be to invest it back into your business. Some options for this would include buying new equipment, or hiring more staff. You can also give raises to your employees to encourage them to stay and reward them for the business success.
- It may also be a good idea to leave some of the excess cash flow on your balance sheet. This way, you will have funds to pay for working capital needs in the future.
- Another option for free cash flow is to take a distribution. If you are a business owner, the ultimate goal would be to make money from your business. If your business is now cash flow possible, you could start taking additional distributions on top of the salary that you already pay yourself.
In conclusion, having access to free cash flow is important for any business. Before determining whether a business is successful or not, the company must be able to know how to calculate free cash flow. Once they are able to properly test their cash flow, they should look for ways to improve it through higher sales or lower expenses.
Finally, a business will need to carefully consider what to do with its free cash flow after all expenses, capital costs, and taxes have been paid.
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