While certain companies appear to be fast-growing with healthy earnings, just looking at top-line numbers can be deceiving. Business owners may often overlook a key indicator of financial health. So-called “free cash flow” (FCF) is essentially revenue minus both the cost of goods sold and operating costs plus dollars spent maintaining or investing in assets. It represents the cash a firm has generated for its shareholders after paying its expenses and investing in its growth.
“Profit, to me, isn’t nearly as indicative of company health as cash flow. Profits are impacted by a variety of accounting wizardry techniques and are also harmed by non-cash and non-operating expenses such as depreciation, amortization and taxes. Cash is king, and you can’t run your business day to day without it,” says Jeff Haydock, president and CEO of ecoCFO.
Free cash flow is essentially the cash left before you pay your taxes and account for depreciation and amortization losses. The health of your FCF is an important indicator of how your overall business is performing.
“FCF is critical to small and medium businesses because most of the time, those businesses are living off their cash. They don't have access to extensive financing and do not have big piles of cash to help them grow, like a larger company might,” notes Lori Atwood, founder of Lori Atwood - Fearless Finance and a financial advisor to small businesses. In addition to using free cash flow forecasting to help business owners understand the sales levels needed to hit their profit goals, Atwood also taps it as a tool for valuing businesses.
“When evaluating an opportunity, FCF estimates are made for several years and discounted back to today to see if the venture would make money. FCF forecasting is just as important for business owners because it shows them what their business could be doing, and how much needs to be sold to get to their desired size and profit level,” she says.
How to standardize free cash flow assessment
To effectively use free cash flow to gauge the health of your business, try to make the assessment as standardized and simple as possible.
- Develop a template and calculate FCF each reporting period.
- Look for trends. “Think about the trajectory of your cash flow. Is the direction going up? If so, how steeply? Do not sweat bad years or months if the trajectory is generally upward,” Atwood advises.
- Evaluate what was happening in your business when FCF was up and/or down. Did you lose a valued salesperson, land an important new client or earn press coverage? “Use FCF to help you learn how to predict what may happen to your business in the future,” she says.
- Set targets and determine your goals for FCF spending.
Too much free cash isn’t necessarily a good thing, as it may mean, “you are not investing in the assets you’re going to need as your company grows, and you might actually be stunting your growth,” Haydock says. Low overhead, minimal assets, and a high gross profit margin may all contribute to substantial free cash flow and indicate that it’s time to look for smart ways to invest that cash.
Haydock suggests investing in new assets that will generate more revenue or reduce operating expenses. These may include new IT systems or manufacturing equipment, for example.
“Many of these investments can act as tax shelters for you now and down the line. If you think you might need liquidity in the near future, invest in short term securities that are easily sold,” he advises. “Ultimately, don’t blow your cash on non-performing assets that depreciate in value, like an expensive car or a yacht.”