What is Free Cash Flow?
Free cash flow (FCF) measures a business’s cash available after paying its operating expenses and capital investments.
The main reason people start small businesses is usually to pay for their life expenses from their own business. Sadly though, it is also one of the common reasons small businesses fail. That is, when owners extract too much cash out of the business that the business can no longer sustain its operations or invest to grow & survive.
Free Cash Flow Formula
There are many ways to calculate free cash flow (FCF) and all of them give the same result, so here we will use the simplest one .
Free Cash Flow = Cash From Operations – Capital Expenditure
Cash from Operations
You can extract the figure for Cash From Operations from your cash flow statement.
CFO =
Cash you received from selling your products
– Cash you paid to operate the stores (rent, salaries, admin, marketing,..etc)
– Cash you paid to your vendors for your products
– Interests
– Taxes
– Other miscellaneous payments related to operations.
Capital Expenditure
Capital Expenditure or CAPEX is the the capital you invest in the business. This could be to buy new equipment, build new stores, buy a property,..etc.
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Cash Flow vs. Net Profit
Many new business owners assume that making that amount of net profit at the end of the year automatically means they can get that same amount out of the business and use it for their expenses.
This is , however, not true. The method used to calculate net profit in your P&L statement doesn’t reflect the amount of cash coming in or going out of the business for the same year.
For example:
If you invest 10,000$ in a new equipment this goes straightaway out of your bank account at the time of investment, and hence reduces your cash by 10,000$.
On your P&L however, this amount is spread out over ,say, 5 years and recorded at 20% (2000$) each year. So it will appear as 2000$ of depreciation and deducted from your profits each year for 5 years.
What Does That Mean For My Business?
It means that you can be operating a very profitable store, yet you are not able to pay the bills month in and month out, due to poor cash flow management. This will reduce your ability to take money out of your business or invest more money into growing & expanding your business.
Your cash could be trapped due to having too much inventory, for example, or due to poor collection of invoice payments from your customers. This could also mean that you will have to take out a loan or line of credit to meet all your payment deadlines, which will put additional cost of interests on you in the future.
Understanding all those dynamics will allow you to operate your retail or e-commerce business differently.
For example, you might be tempted to take that great offer the supplier is giving you of 20% off if you purchase more stocks. You might think “That’s great! This means higher margin and more profits for me“. However; now that you know what effect this will have on your cash flow and inventory turnover, you will think again and weigh all the pros & cons of taking that offer.
You will also understand that sometimes it is ok to take a loss on some obsolete stocks, just to be able to free up cash flow for the business. It is actually the wise thing to do in this case, although it results in loss on this inventory.
That’s why we always advice any retail or e-commerce business owner to look at their retail financial statements as a whole, and not only on the P&L statement.
Learning how to read and interpret each statement and how to connect them all together with other retail metrics will definitely improve the financial performance of your retail business over time.
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More Resources
Thank you for reading this article on Free Cash Flow. We recommend the below free resources as well:
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