Despite the many ratio’s and financial indicators that are available to owners, the continued financial viability of a business hangs on that continuous availability of cash. There is a lot of truth is the old adage – Cash Is King. Yet, despite the acknowledged importance of cash to a business I am amazed that so few owners truly manage cash. This post looks at a key cash management strategy – Free Cash Flow.
Unlike numerous other indicators, Free Cash Flow is focused on the cash that is generated by a business minus various uses of cash. It is important because it is an indication of the companies ability to take advantage of new business opportunities and as an indication of financial health of the business. While it is useful to many of the stakeholders, such as investors, as an gauge of the potential cash available for distribution, it is an indispensable to owners.
Free cash flow can be determined in a variety of ways, depending on the financial information available and the group for whom it is intended. One common formula is as follows:
- net Income plus (add back depreciation and amortization) plus or minus the change in working capital minus any capital expenditures and minus any dividends paid
While improving the operations of the business is the ideal way to improve free cash flow, there are other ways that can show that free cash flow is improved but they are not necessarily beneficial to the long term financial health of the business. For example, payment of accounts payable can be delayed, routine maintenance can be postponed or reduced, or the declaration and payment of a dividend can be deferred. These increase free cash flow in the the short term, but are not beneficial in the long term.
Examples of actions that owners can take that improve free cash flow and are positive business improvements include accelerating the collection of accounts receivable or implementing just-in-time inventory management systems. Other improvements in working capital (current assets minus current liabilities) will generate similar positive results.
Owners need to be aware that rapid growth can have a negative effect on free cash flow, particularly if the growth results in substantial increase in inventory. Similarly, increases in accounts receivable as a result of the growth in sales will also reduce free cash flow. It is vitally important that owners pay close attention to free cash flow during a time of rapid or accelerating growth or the company can easily become cash starved.
This post has looked at free cash flow as a key indication of the financial health of a business and reviewed several ways that free cash flow can both be improved and diminished. Also, the impact of some actions that improve free cash flow in the short term with detrimental long term effects was also addressed.
Some concepts taken from Business Ratios Guidebook by Steven M. Bragg, July 2013