Free cash flow: what it is and how to calculate it

Free cash flow is the cash a business generates after paying its running costs and after spending on the assets it needs to keep operating. In plain terms, it is what is left that the business can use freely: to repay debt, pay owners or build a reserve.

The British Business Bank defines cash flow as the amount of cash that comes into and out of your business in a particular period of time. Free cash flow takes that one step further by subtracting the money spent on fixed assets, because that spending is not optional if the business is to carry on trading.

The most common formula is free cash flow = operating cash flow − capital expenditure. Operating cash flow is the cash produced by trading, and capital expenditure is money spent buying, maintaining or improving fixed assets.

The British Business Bank’s glossary describes capital expenditure as funds used by the company to buy, maintain or improve its fixed assets such as buildings, vehicles, equipment or land. Day-to-day running costs belong in operating cash flow instead.

Be aware that definitions vary. Some people treat loan interest as part of operating cash flow and some deduct it separately, and some deduct lease payments. Pick a definition, write it down and apply it the same way each time.

To calculate free cash flow, start with operating cash flow, then deduct what you spent on fixed assets. The numbers below are round and made up, to show the arithmetic.

If you only have a profit and loss account and a balance sheet, you can build operating cash flow from them, which the next section explains. If you have a bank statement, the shortcut is to total the cash in and out of trading for the period.

Free cash flow follows money moving in and out, whereas profit is revenue minus costs on paper. The British Business Bank describes net profit as the total revenue you have generated from sales minus the total amount you deduct as a legitimate business cost, and that does not say when the cash actually moved.

Three things typically pull the two apart:

• Unpaid invoices: a sale counts as revenue when you make it, but the cash arrives later.
• Stock: buying stock is a cash cost now, even if the profit comes when it sells.
• Depreciation: this reduces profit but is not cash leaving the account.

This is another made-up illustration of the arithmetic. It shows how a business reporting a profit can still have negative free cash flow. For the profit side, see our guide to net profit.

No. Negative free cash flow is a warning only if it is unplanned or lasts, because a business that is investing for growth often spends more cash than it earns for a while. The British Business Bank notes that growth often causes cash flow problems, because each sale must be funded by working capital, a business must carry stock to grow, and customers often receive credit.

The question is whether the cash gap is a deliberate investment with a clear payback or a sign that trading is not producing enough cash. A sustained period of negative cash flow, the British Business Bank warns, can make it hard to pay bills and other expenses.

• Planned: a one-off equipment purchase that will raise future output.
• Worth investigating: free cash flow stays negative while profit is positive and customers are paying more slowly.
• Urgent: cash is running out before the next payment date. Talk to your accountant early.

To see a gap before it arrives, build a cash flow forecast and update it as the year goes on.

Working capital changes flow straight into operating cash flow, so tying up more money in stock and unpaid invoices lowers free cash flow. Our guide to working capital explains the cycle behind it.

That is why the practical levers are often working capital levers: invoicing promptly, chasing debtors, ordering stock closer to demand and agreeing supplier terms that match how customers pay you. These cost nothing in interest.

Lenders look at cash flow because loans are repaid in cash, not in profit. A lender may ask for bank statements or accounts to judge whether the business generates enough cash to meet repayments, and each lender sets its own criteria.

The British Business Bank says banks use EBITDA to understand a company’s ability to generate cash flow, and that a loan agreement may include a ratio you must keep to. Our guide to EBITDA covers that measure, and the interest cover ratio shows one common test of whether earnings cover the interest bill.

You improve free cash flow by bringing more cash in sooner, spending less on running costs and timing capital spending carefully. Start with the steps that cost nothing.

• Invoice as soon as work is done and agree clear payment terms.
• Review stock and reduce lines that are not selling.
• Spread the cost of a large asset instead of paying in one go, if the total cost is acceptable.
• Check overheads and subscriptions every quarter.

If a gap remains, the right finance depends on the cause. Slow-paying customers point to invoice finance. Buying vehicles or machinery points to asset finance. All finance costs money, and any approval is subject to status and lender criteria.

Capzy is a credit broker, not a lender, and is paid by the lender. We do not give accounting or tax advice, so ask your accountant to check your cash flow figures. We introduce businesses to lenders whose products may suit their needs.

You can check your funding options with a soft search that does not affect your credit score. A full application to a lender may involve a hard search, and any offer is subject to status and lender criteria. The lender directory groups lenders by product type.