Accounting & Finance

What is Free Cash Flow? Small Business Finance Tips

As a small business owner, you constantly evaluate your company’s financial health. You review your financial statements, analyze your income and expenses, and scrutinize your budget. With all this focus on financial data, you may be hearing a lot about free cash flow but not entirely sure what it is or how it applies to your business. In this blog post, we’ll define free cash flow and explain why it’s important for small business owners.

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What is Free Cash Flow?

Free cash flow is the money that your business generates after accounting for all the expenses required to maintain and grow your operations. This metric measures the amount of cash your business has available to invest in growth opportunities, pay dividends, or repay debt. Free cash flow is a more accurate indication of your business's financial health than profit alone since it takes into account non-cash expenses like depreciation.

Benefits of Free Cash Flow for Small Business Owners

Free cash flow offers numerous benefits to small business owners. As a vital financial metric, it provides a clear and comprehensive picture of your company's ability to generate surplus cash, which can be reinvested strategically to spur sustainable and long-term growth. This surplus cash can be used to improve operations, fund new product development, expand into new markets, or invest in innovative technologies to gain a competitive edge.

In addition, free cash flow is an excellent indicator of your company's financial stability, which is crucial when seeking external financing. Lenders and investors often consider free cash flow when assessing the risk associated with lending to or investing in your business. A healthy free cash flow demonstrates your company's ability to meet financial obligations and generate returns on investment, increasing your chances of securing favorable terms and attracting potential investors.

Related Reading: Am I Lendable? How to Get Business Financing

Tracking free cash flow can help you identify potential financial challenges early on, allowing you to take proactive measures to address them before they become significant problems. By regularly monitoring and analyzing your free cash flow, you can detect trends, pinpoint areas of improvement, and make informed decisions to optimize your financial performance. This proactive approach can help you maintain financial stability and navigate through uncertain economic conditions with greater confidence.

Limitations of Free Cash Flow for Small Business Owners

While free cash flow is a valuable tool for assessing the financial health of a business, it does have some limitations that small business owners should be aware of.

  • Company Cash Cycle: Free cash flow is heavily influenced by the company's cash cycle, including accounts receivable and accounts payable. For instance, if your clients consistently pay their invoices late, it can artificially decrease your free cash flow. Conversely, if you delay payments to suppliers, it can artificially inflate your free cash flow.
  • Future Expenses: Free cash flow doesn't account for future capital expenditures that might be necessary for growth. If your business is in a phase of aggressive expansion, you may have significant upcoming capital expenditures that are not reflected in your current free cash flow.
  • Financial Insights: Lack of free cash flow is a measure of financial performance based on the past and present. It doesn't provide insights into future profitability or cash flow, which can be influenced by changes in the market, competition, and other external factors.

Therefore, while free cash flow is an important metric, it's not an all-encompassing measure of a company's financial health. It should be used in conjunction with other financial metrics and qualitative factors to provide a comprehensive view of your business's financial position.

How to Calculate Free Cash Flow?

There are several different methods to calculate free cash flow, but one of the most widely used formulas is subtracting capital expenditures from operating cash flow. Operating cash flow represents the cash your business generates through its day-to-day operations, encompassing revenue from sales, investments, and other income sources. On the other hand, capital expenditures refer to the expenses incurred to maintain and expand your business, including the costs for new equipment, renovations, and infrastructure improvements.

By deducting capital expenditures from the operating cash flow, you can ascertain the free cash flow for your business. This metric provides valuable insights into the financial health and sustainability of your operations, allowing you to make informed decisions regarding investments, debt management, and potential growth opportunities. Understanding and effectively managing your free cash flow is crucial for maintaining a solid financial foundation and driving long-term success.

Related Reading: 3 of The Best Small Business Accounting Software

Tips for Improving Free Cash Flow

There are several effective strategies that you can implement to improve your business's free cash flow:

  1. Increasing sales: By implementing targeted marketing campaigns, improving customer retention strategies, and exploring new markets or sales channels, you can boost your business's revenue. The more revenue your business generates, the more free cash flow you will have available to reinvest or use for other purposes.
  2. Reducing expenses: Identifying areas where you can cut costs can have a significant impact on your business's free cash flow. Evaluate your expenses, such as rent, wages, utilities, and other overhead costs. Look for opportunities to negotiate better deals with suppliers, optimize your operations to eliminate waste, and explore cost-saving measures without compromising the quality of your products or services.
  3. Managing inventory: Efficiently managing your inventory levels is crucial for optimizing your business's free cash flow. Excessive inventory can tie up valuable resources and lead to storage and holding costs. On the other hand, insufficient inventory can result in missed sales opportunities. By implementing inventory management systems, forecasting demand accurately, and establishing strong relationships with suppliers, you can strike the right balance and reduce costs associated with inventory management.

By implementing these strategies and continuously monitoring and adjusting your approach, you can improve your business's free cash flow and ensure long-term financial stability.

Do Business Loans Require Free Cash Flow Calculations?

In many cases, lenders will require a business to provide detailed free cash flow calculations when applying for a loan. This gives the lender insight into the company's financial health and ability to repay the loan. Free cash flow is an important metric that can help lenders determine whether or not they should approve a loan request.

When submitting your application, it is important to provide detailed free cash flow calculations that accurately reflect your business's financial position. This should include a comprehensive overview of all revenue sources, expected future capital expenditures and operating expenses, as well as the total amount of debt that you are seeking to borrow. With this information, lenders can make an informed decision on whether or not they will approve the loan request and at what terms.

However, it is possible to qualify for a business loan without demonstrating free cash flow, although it may be more challenging. Lenders typically prefer to see a positive free cash flow as it indicates a business's ability to repay the loan. However, they also consider various other factors when assessing a loan application. These may include the business's credit history, collateral, balance sheet, and overall business plan. Additionally, the owner's personal credit score and financial situation can also play a significant role. If a business doesn't have free cash flow, presenting a solid case in these other areas could offset this and increase the chances of securing a loan.

Discover the Right Loan For Your Business

As a small business owner, it’s essential to have a thorough understanding of your business's financial health, which includes tracking your free cash flow. Measuring your business's cash generation is vital to its overall success, sustainability, and access to capital. Are you ready to explore different lending partners to launch your business to new heights? Explore our Capital Marketplace today and discover the right lender for you! New call-to-action