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Published on 2024-11-06
Understanding how your business is performing requires advanced analysis, not only looking at sales and profit numbers. For example, cash flow and other financial ratios are top data that entrepreneurs and executives look at before investing or buying stocks in your company.
The free cash flow analysis provides insights into the amount of money available after deducing all expenses and debts. However, there’s more to it, so let’s explain the FCF in more detail.
Explaining the Free Cash Flow
The free cash flow analysis measures how much money is generated from business activities and after paying debts and expenses, including new expansions and asset capital.
This figure is important because it reflects how much money is left for shareholders to receive dividends, issue share buy-back programs and invest in new business lines or projects.
Many analysts calculate the FCF to measure the capital inflow and outflow and prepare a fund statement.
The Free Cash Flow calculations involve the identification of multiple components that are used in the formula, including operating cash flow, capital expenditures and changes in working capital. Let’s explain them.
Operating Cash Flow
OCF is the amount of money generated through business operations, including capital inflows and outflows via sales and marketing.
For example, if a company’s revenue is estimated at $50 million but its operating expenses (salaries and rent) equal $20 million, the remaining $30 million is the operating cash flow.
Capital Expenditures
CapEX is the capital allocated by shareholders and executives to expand resources like raw materials, new property or equipment.
For example, industrial facilities have significant capital expenditures, which leads to lower operating FCF. However, they can generate substantial returns from large-scale sales in the long run.
Working Capital Changes
Changes in the working capital involve the difference between assets and liabilities, as well as the ratio between them, as they can highly impact the available free cash.
Companies undertake different activities to reduce assets, like selling equipment and paying debts off to decrease liabilities.
Calculation Formulas
The free cash flow can be calculated in two ways depending on the available components to measure the remaining funds after costs.
1. FCF = Operating Cash Flow - Capital Expenditure
A straightforward way to measure free cash flow after paying operating and investment expenses, showing liquidity available for growth.
2. FCF = Net Income + Non-Cash Cost - Working Capital Changes - Capital Expenditure
This way, it adjusts net income for non-cash expenses and working capital changes, offering a detailed view of actual cash flow generation.
Conclusion
The free cash flow reflects the amount left after a business pays its investment and essential costs. Calculating the FCF gives insight into a company’s performance and ability to expand into new business lines or pay dividends for shareholders.
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