The Importance of Free Cash Flow
In business finance, there is one concept that often stands far above the rest: free cash flow. While many focus on profits, the reality is, as I often say, "You can't eat profits.". What actually sustains and grows businesses is the available cash after operations and necessary investments - this is where free cash flow comes into effect - an essential analysis of financial health and operational efficiency.
IN THIS ARTICLE:
→ What is Free Cash Flow?
→ Why is Free cash Flow Crucial?
→ The Impact of Free Cash Flow on Business Sustainability
→ Cash Flow vs. Profits: the Common Misconception
→ The Role of Free Cash Flow in Valuation
→ How to Improve Free Cash Flow
→ How a Virtual CFO Can Impact Your Free Cash Flow
What is Free Cash Flow?
Free Cash Flow (FCF) is a fairly straightforward calculation that has a powerful impact revealing how much cash your business will generate without depending on debt or working capital. Here's the formula:
Free Cash Flow = EBIT ± Movement in Working Capital ± Movement in Fixed Assets
- EBIT (Earnings Before Interest and Tax): Your business's operational profit before accounting for financial obligations.
- Working Capital: The difference between your current assets and liabilities - essentially the cash currently tied up in operations.
- Fixed Assets: Investments in long-term assets like equipment, machinery, and or property.
Let's break it down with a hypothetical scenario:
- You have $200,000 in EBIT.
- Working capital increased by $50,000 (meaning more money is tied up in stock, receivables, etc.)
- You have invested $20,000 in fixed assets.
So in this instance your free cash flow would be:
$200,000 (EBIT) - $50,000 (Working Capital increase) - $20,000 (Fixed Asset Investment) = $130,000 in Free Cash Flow
Conversely, if your working capital had decreased by $50,000, and you sold an asset for $20,000, your free cash flow would rise to:
$200,000 + $50,000 + $20,000 = $270,000
Why is Free Cash Flow Crucial?
Free cash flow tells you how much money your business is truly generating. Filtering out the effects of working capital adjustments and fixed asset investments, offering a more accurate reflection of your financial standing.
Here's why it matters:
- Cash Availability: Free cash flow shows how much money is actually left over after operational expenses and necessary investments, which can be used for growth, debt repayment, or even distributions to owners.
- Operational Independence: It highlights how well your business generates cash without relying on borrowing or tying up money in working capital.
- Investment Management: Businesses that don't require heavy reinvestment into fixed assets will usually generate more free cash flow, making them more resilient and self-sufficient.
The Impact of Free Cash Flow on Business Sustainability
Knowing your free cash flow number will greatly aid in the long-term sustainability of your business. This can come in the form of:
- Business Resilience: A healthy free cash flow allows businesses to navigate economic downturns, seize growth opportunities, and maintain stability (even in times when profits are low!).
- Avoiding Reliance on External Funding: By having free cash flow as a buffer, you can reduce your dependancy on loans or external investment to keep operations running smoothly or finance growth.
- Self-Funded Expansion: If you're performing well and have a strong cash flow, you can reinvest into new markets, expand production, or take on larger projects without needing to secure additional outside funding.
- Flexibility for Innovation: Companies with healthy cash flow can make strategic decisions faster than competitors reliant on external capital.
Cash Flow vs Profits: The Common Misconception
Profits aren't the full story. Some owners will believe that as long as they're profitable, they will be financially secure - but this couldn't be further from the truth. If cash isn't readily available due to high working capital needs or heavy reinvestments into the business you're going to run into issues fast. What if the scope of the project increases or there is time bloat? Will a 1% profit margin help protect you?
If you want to know more about what kind of profit margins you should aim for in your business, for $0 and 30 minutes of your time watch my masterclass on business margin and how not all profits are equal. You'll thank me later.
The Role of Free Cash Flow in Business Valuation
If you're looking to either grow or sell your business, free cash flow is an important metric to know as it will help with:
- Business Attractiveness: Potential buyers and investors will focus on free cash flow to assess the value and health of your business. Free cash flow is a key metric in determining whether a business will be able to provide returns without excessive capital injections.
- Planning for Exit: If you're thinking about selling your business (contact us now!) starting to improve your free cash flow now will greatly help boost your business value and overall attractiveness.
How to Improve Free Cash Flow
Now that we understand what free cash flow is, how do we improve it? As suggested by the formula, there are three key levers to pull on:
- Increase EBIT: Focus on profitability. Whether through direct cost reduction, pricing strategies, or operational efficiency improvements, growing your EBIT will have a very impactful change on your cash flow.
- Optimise Working Capital: Manage stock levels better, collect receivables faster, and negotiate favourable payment terms with your suppliers. The more cash you can manage to free up from your working capital pipeline, the better your cash flow will be.
- Smart Asset Investment: Only invest in assets that will have a genuine contribution to income and profit generation. Avoid any vanity purchases - buying new vehicles might feel good, but if it isn't adding any value, it can and will hurt your free cash flow. Every asset should have a clear return on investment. If you feel insecure about your next big investment let me do an elite analysis for you.
Ask yourself: Are you generating enough cash to fund your growth, or is your business constantly tied up in stock, receivables, or debt?
The answer to that question, will guide your next steps to achieving a healthier and more sustainable business model.
How Can A Virtual CFO Impact Your Free Cash Flow
A Virtual CFO can have significant impact on free cash flow by providing strategic financial oversight, guidance and optimisation. Let's explore how this works in practice and the ways a Virtual CFO can help improve your free cash flow:
1. Expertise in Cash Flow Management
One of the primary benefits of having a Virtual CFO is their expertise in cash flow forecasting and management. They help business owners understand their current financial situation and project future cash flows. Here's how:
- Cash Flow Forecasting: A Virtual CFO can build detailed cash flow models predicting future inflows and outflows based on historical data, sales forecasts, and market trends. This allows you to anticipate shortfalls or surpluses and plan accordingly.
- Scenario Planning: Virtual CFO's can also perform "what-if" scenarios, helping you understand the impact of different business decisions on free cash flow. For example, how would a new product launch, equipment purchase, or hiring impact your liquidity?
2. Optimising Working Capital Management
A Virtual CFO's experience in optimising working capital can have a direct and immediate effect on free cash flow. Through a combined approach of operational tweaks and strategic advice, they can free up cash that's tied to the business. Specifically they can:
- Reduce Debtor Days: Streamline accounts receivable processes, ensuring that customers pay promptly. This might come in the form of automated invoicing systems or by implementing stricter payment terms.
- Manage Stock Efficiently: A Virtual CFO can provide advice on maintaining optimal inventory levels, avoiding overstocking, and negotiate better payment terms with suppliers. By holding just the right amount of stock, cash that would traditionally be held up in inventory will now become available.
- Control Creditor Payments: They can manage payment terms with suppliers, so you can get the most out of your cash position without straining supplier relationships. It means ensuring you pay within terms, but not prematurely, allowing the most amount of cash to stay within your account for the most amount of time.
3. Strategic Investments in Fixed Assets
A common issue impacting free cash flow is the mismanagement of capital expenditure (CapEx). Without proper planning, a business can over invest in fixed assets that will not produce immediate or significant returns, and as a result, reduce available cash. A Virtual CFO helps this by:
- CapEx Planning: They will ensure that any investments in fixed assets (think equipment, vehicles, or property) are aligned with your business goals and cash flow capabilities. They focus on ensuring that these investments will produce income or at the very least, improve operational efficiency.
- Avoiding Vanity Purchases: With a Virtual CFO at your disposal, you'll have a financial partner who will ensure you invest in assets that will drive profitability, rather than making unwise purchases that negatively impact your free cash flow.
4. Improving Profitability and EBIT
By helping improve your business's profitability, a Virtual CFO will enhance your free cash flow. EBIT (Earnings Before Interest and Tax) is a key component in free cash flow calculations, and increasing it directly improves cash availability. Hiring CFO Dynamics as your Virtual CFO can help by:
- Identifying Cost-Saving Opportunities: Whether through renegotiating supplier contracts, reducing overhead costs, or streamlining processes, we will look for ways to lower costs whilst maintaining and improving quality.
- Revenue Growth Strategies: Working closely with your leadership teams to devise strategies that will generate revenue - such as entering new markets, improving pricing models, or expanding product lines.
- Profit Margin Optimisation: By focusing on maximising margins, more revenue will translate into higher profits, which will boost cash flow.
5. Access to Strategic Funding Options
While free cash flow ideally comes from operational efficiency, there will still potentially be times where external funding is required. Having a Virtual CFO will help manage strategic funding options which will improve your liquidity without over-leveraging your business.
- Debt Management: A Virtual CFO can provide advice on if debt financing will be appropriate for your business, and ensure that if the debt is taken on, it won't impair your cash flow. It might mean renegotiating terms on existing loans or helping to secure new financing with better rates.
- Equity Investment: Where appropriate, a Virtual CFO can help secure equity funding that provides an injection of cash without the need for repayment, boosting your liquidity while preserving cash flow.
6. Freeing Up Business Owner's Time and Focus
One of the most often-overlooked benefits of having a Virtual CFO is how they will ultimately free up the business owner's time. Instead of focusing on the intricacies of financial management, owners can focus on growth, strategy, and operations. This creates a ripple effect on free cash flow, as:
- Better Decision-Making: With a Virtual CFO providing accurate financial insights, business owners can make quicker and more informed decisions that enhance profitability and cash flow.
- Operational Focus: A Virtual CFO will help refine operations to run smoothly and more efficiently, reducing bottlenecks and aiding in cash-generation activities.
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