Free cash flow (FCF) is all the difference between money made from normal business operations and money spent on fixed assets. It shows your company a steady financial condition and health, as well as ability to continue in business. In accounting, the term cash flow is also called earned cash running cash (ACF), and the money spent on fixed assets is known as fixed capital expenditure (CAPEX). Whether you are a small business owner or a large corporation, understanding your FCF is crucial to the success of your business.
When measuring free cash flow, you first must establish what type of metrics you want to use. The three most common types of metrics used are the gross profit/ loss, net income, and net operating cash flow. The gross profit/ loss should be considered the current value of the sales you have just completed, while the net income is what your business is bringing in before you charge it to your customers. The net operating cash flow is considered the future value of what your company will earn based on the amount of purchases your customers make today, as well as any ongoing purchases your customers make through your company.
Both of these measurements are important to your free cash flow measurement. Your gross profit/ loss will show you how much profit your company makes on a monthly basis. Net income tells your organization, how much money it is earning after all of its expenses are deducted. It can be an accurate reflection of the health of your business, if it indicates that your company is gaining customers, but not spending money. You should always keep an eye on both of these measurements as they are indicators of the overall financial health of your business.
A free cash flow analysis is usually performed by a Certified Public Accountant (CPA). In order to prepare your free cash flow statement, the CPA will gather information from the income statement, balance sheet, and statement of cash flows. You will also need your tax return and pay stubs. Your CPA will then work with you to develop an accurate analysis for your free cash flow statement. This analysis is used by your company to determine its liquidity, its debt, its equity, and its capital structure.
In order to prepare your free cash flow statement, the CPA will compare the operating expenses, inventory, sales, and assets against your revenue and taxable income. He will take these three items and calculate what your net income and net debt are based on them. If your gross profit is lower than your expenses, your net income will be higher. Conversely, if your expenses are higher than your revenue, your net income will be lower. The difference between your net income and net debt is your net worth.
Net Worth allows your CPA to determine your free cash flow situation using your Net Worth Statement and your income statement. If your net worth is negative then your company could be headed towards bankruptcy. On the other hand, a positive net worth statement indicates that your company has enough funds to meet its expenses and its obligations. In order to make sure that your company maintains an adequate level of net worth, you will need to pay regular dividends.
Regular dividends will improve your free cash flow if your company receives enough of them. However, you should be careful about paying too many of them. Too many dividends will reduce your company’s share value and reduce your company’s ability to receive additional dividends from its operating activities. Dividends are generally used to increase the liquidity of a company by offsetting losses from its various operating activities.
Your CPA will use these two figures, your Net Worth Statement and your Income Statement to calculate your free cash flow. You will then be able to determine how much you need to borrow from external sources, such as banks or other investors. The more money you can borrow, the higher your company’s capitalization will be. By increasing the value of your holding, you increase the net worth of your corporation while reducing your interest expense and your operating expenses.