If Cash Flow Matters, Free Cash Flow Is Critical
Understanding the difference between current liquidity and long-term company health.
Cash flow is critical in meeting obligations on debt and shareholder distributions, paying owner tax obligations (LLC or S-Corp.), and growing a business’s balance sheet over time. Free cash flow is typically used to describe remaining cash flow after unfinanced capital expenditures, cash distributions, and cash tax obligations are fulfilled. Free cash flow services debt with residual post-debt service cash returning to the balance sheet to strengthen a business.
While “free cash flow” isn’t a term you hear often, it is a real indicator of true long-term performance and health, whereas “cash flow” is more about solvency/liquidity at any given time.
In terms of calculations, cash flow is generally earnings (or operating income) before interest and taxes, depreciation and amortization (EBITDA). The typical calculation is net income plus interest, taxes, depreciation, and amortization. Depending on the consistency of cash income below the operating income line, it can be added to cash flow generation. Free cash flow usually removes cash obligations, including taxes, distributions, and/or capital expenditures not financed by debt.
In simpler terms, consider cash flow the sum of operating, investment, and financing cash flows, while free cash flow is operating cash flow less capital expenditures. The key difference between the two: cash flow is the movement of cash within an organization resulting in either an increase or decrease in cash, while free cash flow is the availability of cash that can be distributed to stakeholders.
A positive free cash flow shows that the company is generating enough cash to run efficiently at any given time, while a negative free cash flow shows that either the company is unable to generate sufficient cash or has invested money somewhere else, which may generate higher returns in the future.
Improving free cash flow
So how can you bolster free cash flow? Organically, there are really only two ways to improve cash flow: through greater volume (revenue generation), or by creating higher efficiencies (profit margin/operating profit). Free cash flow can be improved through financing major capital expenditures, and management’s ability to retain earnings in the company rather than distribution. If you’re considering improving efficiencies, there are some key areas in your business worth exploring:
- Look closely at all current assets and liabilities. If you’re a manufacturer, for example, look at turnover in your inventory, including all materials on hand, work in progress, finished goods, and supplies. Low turnover means you can scrap the things that aren’t moving and report a loss. The result is lower income taxes and less cash flowing out to support inventory, which frees up cash.
- Keep your eye on accounts receivable/payable. On the accounts receivable side, ensure that you’re being paid in a timely manner and that customers are meeting their credit terms (don’t let late payers lag). It’s all about speed of invoice to cash. On the accounts payable side, it’s about stretching payables and holding onto to cash as long as possible. Don’t pay late, but ensure that you’re not paying early, unless you’ve negotiated a discount to do so.
- Check your pricing. The market changes constantly, regardless of your industry or vertical. Constantly look at all the numbers associated with the cost-of-goods sold and the competition to determine the optimal pricing for your product or service. Looking at the numbers invariably uncovers inefficiencies.
It always makes sense to keep an eye on your critical numbers, and free cash flow can give you a perspective on how healthy your company will be for the long haul. If you have questions about how it works for your business, talk to your accountant or banker to learn more.