Free Cash Flow: A MUST KNOW

Updated: May 1, 2021

Free cash flow is a term thrown around so much that nobody ever really stops to explain what it is or why it matters, a lot! Today I'm going to try to explain it without using an equation.

Imagine you get a call and learn that a long-lost relative has just passed away. The good news is that they have left you a business, a small bakery that makes nothing but cookies.

Like anyone would be, you are curious just how much you will make as the new owner of the business. A few days later the financial statements from your new business arrive and you tear them open to see how much money you'll make.

Unfortunately, you soon find out that the financial statements don't make this figure obvious. At first, you assume you will make the net income of the business, but you remember now that the depreciation and amortization line you see on the income statement is just a way for accountants to stretch the expense of the ovens and other assets over their useful life.

You soon discover that even though the ovens were purchased five years ago (in cash) the business is still depreciating them. You decide that you will be able to take out of the business more than just the net income, but also the depreciation since it is not a cash expense, just an accounting expense.

You spend some more time thinking about your business and decide you want to be a forward-looking owner. You know that the ovens you have won't last forever, nor will the mixers or the conveyor belts. You decide that you will spend money on the property plant and equipment of the business on a regular basis so that you can keep things running smoothly.

You soon realize that when you invest cash in the property plant and equipment of the business the money spent will be capitalized, therefore adding to the value of the assets being depreciated. Not being expensed right away.

You decide that you will have to deduct this extra expense from the amount you can pull out of the business. So, you decide to take the net income, add the depreciation and amortization, and deduct the capital expenditures (the money you are going to spend on new ovens).

You calculate the amount you think you'll be able to pull out of the business after the year is over and call it free cash flow.

Net income $100

Add: Depreciation and amortization $20

Less: Capital expenditures $25

Free Cash Flow = $95

When the year is over you go to the bank and attempt to pay yourself the much-needed $95. To your horror, you only find $85 dollars. You think back on your first year of business and remember that one of your customers was going through a rough patch so you let them give you an IOU as compensation. You recorded this transaction as follows:

Accounts Receivable $20

Revenue $20

The problem is that you recognized the sale and added it to your income statement but never actually got around to collecting the IOU. The money was showing up on the income statement but had not reached your bank account.

Still, a $20 IOU doesn't explain a $10 dollar difference in your free cash flow. You realize that not only did you sell to the customer on credit, but you yourself have an outstanding $10 IOU for machine servicing

Machine Servicing Expense $10

Accounts payable $10

The $10 increase in accounts payable is money you have not had to take out of account yet. The net change in your working capital is in fact $10. In this case, the $10 increase in your networking capital reduced your free cash flow by $10.

Your new equation is:

Net income $100

Add: Depreciation and amortization $20

Less: Capital expenditures $25

Less: Increase in net-working capital $10

Free Cash Flow = $85

Finally, you have arrived at the proper free cash flow figure for your business. Next year, you will be able to better estimate just how much money you can pull out of your business.