What is free cash flow and how can you achieve it?
The finances of small businesses are often precarious if not downright volatile. This is doubly true for many startups, which frequently operate on razor-thin margins with little working capital and cash flow. A healthy free cash flow (also known as FCF) is paramount to success for startups and small businesses, and a sign of great financial performance. But, cash flow isn't always easy to monitor, let alone secure.
To help your business get on track and stay there, let's take a look at what free cash flow is and why it's important. Then, we'll cover how you can calculate it and how you can give your cash flow a little boost while you're at it.
What is free cash flow and why is it important?
Free cash flow is essentially revenue that's unspoken for, minus capital expenses — necessary equipment or building costs. In order to calculate your surplus revenue, you'll need to calculate operating expenses, interest expenses, and any other cash expenses that might eat into your income.
A positive free cash flow statement means you have more money coming in than going out, even after operating activities and so on. A positive cash flow is ideal, as it means you're building up cash reserves and in good financial health. When positive, your company's free cash flow can be used to hire necessary employees, invest in equipment, expand marketing efforts, and more. Positive free cash flow is also essential to paying creditors or paying off interest you might owe.
A negative free cash flow is the opposite of the aforementioned positive one, meaning you have more money going out than coming in. This is a sign that your business is heading in the wrong direction. Negative cash flow can point toward poor sales, bad profit margins, costly business operations, and a number of other issues. This is why it's important to understand and calculate your free cash flow.
How to calculate free cash flow
There are a few ways to calculate free cash flow. Each FCF formula offers a slightly different view of your finances. Let's start with the first free cash flow formula:
Cash flow from operations + interest expenses – tax shield on interest expense – capital expenditures = FCF
If you don't have any interest expenses factoring into your business, you can also use the more straightforward method that relies on sales and base taxes:
Revenue – operating expenses – taxes – operating expense investments = FCF
The above FCF formula is great for determining free cash flow. But, if you want to predict FCF, you need the discounted cash flow (DCF) formula. Discounted cash flow is used to estimate how much cash flow you can expect from something in the future. This is especially useful for investing and is frequently used in real estate.
Discounted cash flow is especially in-depth, and being the case, so is the formula to find it. Read up on discount cash flow to better understand how you can calculate this predictive type of FCF.
Lastly, there's the formula for finding your unlevered free cash flow. Unlevered cash flow is your FCF without factoring in any interest payments. This is useful for getting an idea of how your company would be performing without any kind of interest or debts.
Gross revenue – capital expenses – taxes – working capital = Unlevered FCF
While unlevered free cash flow isn't necessarily practical for daily use, it can be a great way to see how your company could be doing if you had all debts and interest out of the way. If you need more immediate, actionable information, the first two formulas are your best bet. Now, let's figure out how to boost your free cash flow.
5 ways to boost free cash flow
If you've just run FCF calculations and you're looking at a concerning balance sheet, don't lose hope. There are ways to drive up your operating cash flow in both the short-term and long-term. With these tips you can have a healthy statement of cash flows in no time.
1. Optimize your prices
The right prices on products and services play a large role in net income and overall cash flow. Go through your books and look at any line item that's a product or service being sold. Then, review the process and materials needed to make that product or provide that service, and factor in the cost.
From there, consider looking at any competitors and see what their present value is for similar products or services. Grossly undercutting your competitors might seem like a good way to drive traffic, but it's a bad way to drive profits.
If you're well below your competitors, consider increasing your prices by a responsible amount. When done right, this can increase the amount of cash coming into your business very quickly. A small increase shouldn't have a large impact on business.
When in doubt about how much to increase your price, do some A/B testing with prices or ask prospective customers (or even friends and family) what prices are appropriate.
2. Quickly invoice customers
Accounts receivable is a hot spot for cash flow issues. If you're slow to invoice customers, you're slow to get paid. And, if you invoice customers and they pay late, you're looking at potential cash flow issues.
One of the easiest cash flow measures you can take is quickly invoicing customers. This ensures the customer's purchase is front of mind when they get the invoice. A quick invoice also subtly pushes the customer into thinking, "They invoiced in a hurry, perhaps I should pay in a hurry." Prompt invoice payment ensures you're not out of a product without payment, allowing you to use free cash flow for purchasing more materials, paying bills, and so on.
Don't hesitate to send invoice reminders if customers haven't paid after a certain period. If they have 30 days to pay an invoice, and you invoiced them right away, don't wait until day 30 to remind them. Send them a little nudge a week or two after invoicing.
3. Audit operating expenses and inventory
High operating expenses can quickly and continually eat into your free cash flow. Just like you audited your product cost, go through your operating expenses and ask yourself if you truly need everything you're paying for. For example, you might find you're paying for software you no longer use. It's also not a bad idea to include your utilities in this audit, as it's possible a quick call to your utility providers can lower your bill through a renewed agreement.
You should also audit your inventory. Outside of current assets that actively contribute to your company's success, you should be limiting what sits on your shelves for too long. If there's a certain product that's fallen in popularity, consider cutting its price, selling it, and freeing up that space. This is space that can be filled with bulk orders of materials, which can in turn save you money on production down the road.
4. Negotiate with vendors
Vendors are essentially business partners, especially when you've fostered a great relationship through vendor management. If you have a great relationship with your vendors, reach out and talk to them about reducing prices for the services they provide. There's always a chance they can give you a better deal in exchange for a longer term or even as a thank you for being a loyal client.
If you have a vendor that you've been unsure about for some time, reassess your relationship. Maybe it's time you find a new vendor with better prices and better service.
5. Push for longer payment terms
Longer payment terms on your business credit cards, like you get with the Brex ecommerce card, can allow you to take more time to pay off current periods. For example, let's say you currently have 30 days on your card. This means you need to clear the balance within 30 days or face overdue charges or additional interest. With longer payment terms you can stretch those payments out to 60 days.
But, longer payment terms also means you need to be doubly responsible with your spending. You don't want to wind up with excessive spending and overlap between the payment periods. This can result in heavy interest and greatly impact your cash flow.
Find freedom with free cash flow
Free cash flow is a must, and with the above tips you can get your business on the fast track to a positive cash flow. But, you need to stay vigilant and continue performing audits, price optimizations, and vendor negotiations. The economy doesn't sleep, and any complacency can result in your cash flow falling into the negative.
Healthy free cash flow takes work to achieve, but the end result is both peace of mind and the freedom to grow your business. When your cash flow is in the red, you're unable to make the right moves, hire the right people, and grow in the right direction. But, you can achieve positive free cash flow with a little fine-tuning. And when you get there, you'll be reminded of the reason you went into business in the first place: total freedom.