How to Calculate Free Cash Flow
Learning how to calculate free cash flow can seem daunting at first. However, the process is actually fairly straightforward once you have a sound understanding of what free cash flow is and how it works.
This article is going to explain what free cash flow is and teach you three different ways to calculate it. It will also cover how to create your own balance sheets and business income statements that you’ll need as part of the calculation process.
What Is Free Cash Flow?
The first step to understanding how to calculate free cash flow is to learn what exactly it is. Free cash flow is basically the amount of money that is left over that a company produces once expenditures are factored in. This includes things like repairs and upgrades to business equipment.
The reason free cash flow is such an important calculation is that it provides a good estimate of what a company can theoretically return to investors for a given period. The calculations are far less easy to manipulate than other value calculations like net income and earnings per share.
Where it gets a bit difficult is understanding how to calculate free cash flow correctly. There are currently three main methods for calculating free cash flow. The next section is going to cover those three primary methods in greater detail.
The first method to try for those of you wondering how to calculate free cash flow is shown in the following formula:
Sales Revenues-Operating Costs and Taxes-Investments in Operating Capital=Free Cash Flow
If you are calculating this for your business, you can find the sales revenue and the operating costs/taxes portion from the business statement. The operating capital figure comes from the balance sheet as an increase in fixed assets.
The second method to consider when learning how to calculate free cash flow is explained in the formula written below:
Net Operating Profit After Taxes-Net Investment in Capital=Free Cash Flow
In this formula, the first portion is commonly abbreviated NOPAT. You find it the same way as the first portion of method one where you deduct operating costs from sales revenues using your balance sheet. You find the net investment in capital by using the increase in fixed assets on your balance sheet as well.
The third method you can use when learning how to calculate free cash flow is the simplest equation to follow.
Net Cash Flow from Operations-Capital Expenditures=Free Cash Flow
In this equation, the net cash flow from operations typically comes from the first section of your statement of earnings. The capital expenditures portion comes from the same increase in fixed assets on the balance sheet just like the other two methods.
What’s the Difference Between the Three Methods?
In short, there is virtually no difference between these three popular formulas. The way they calculate the final number is slightly different, but the final number should always be the same with all three calculations.
They all use the final amount of profit left over from operations once your account for all expenses including things like asset purchases.
What to Do If You’re Missing Balance Sheets?
If you have your balance sheet and business statements, calculating free cash flow is easy. It can also be done without these documents, but it takes much more time. If you are missing your balance sheet, follow these steps to create one.
Start by totaling all of the assets your company has. This includes all of the goods and resources that your company currently owns as well as current account holdings. A good place to find values for things like merchandise is invoices from suppliers that your company uses.
It is important to record certain prepaid expenditures like rent and insurance that your company has already taken care of when calculating assets. When listing assets, list them in descending order based on how quickly you can liquidate them.
Now you are ready to begin tallying up all of your liabilities. This includes things like loans, credit accounts with balances, and bonds that are payable. Once you have all the liabilities totaled, minus those from the assets figure. The final number will be your company assets.
When creating a balance sheet, it is important to remember that you typically create them for a specific date range like every three months. Make sure that you are recording all of the relevant account information to get as accurate of a figure as possible.
What to Do If You’re Missing a Business Income Statement?
The steps necessary to create your own business income statement are fairly straightforward and easy to follow.
To begin, start by picking a specific date period that matches your balance sheet period in the previous section.
Once you have decided on a specific period, add up all of your potential income. For businesses where you receive payment later, include expected payments where you have already delivered your goods or services.
Now that you have added up all of the income, you are ready to start tallying your expenses. This includes things like rent and utilities, materials, employee compensation, advertising fees, and other service fees like web hosting.
Once you have tallied the figures, subtract your earnings from your expenses to get your operating profit. To calculate your net profit, subtract any prospective taxes that will need to be paid from your operating profit figure.
Drawing to a Close
You should now have a sound understanding of how to calculate free cash flow for your business. It is important to keep accurate records of your invoices and orders with your suppliers to ensure your business income statements and balance sheets are as accurate as possible. Feel free to try calculating your free cash flow yourself and tell us about your experience.