What is The Role of Finance in Free Cash Flow Projections?

Free cash flow projection is vital as it is at the forefront when determining the intrinsic value of any business. It is defined basically, as the amount of cash that is left over after a company pays its bills to keep a business running.

The bills will typically include supplies, staff wages, utilities and any other expenses that are important for the company to remain in business. A company that has a healthy cash flow is one that is making enough money for it to operate. It also shows that their products and services are in demand in the market and costs are being properly managed.

Finance team doing free cash flow calculation

Taking out a loan to sustain cash flow from banking institutions whose main purpose is to support small businesses is an option that allows entrepreneurs to stay on top of their finances. However, before you decided whether a business loan is the best option for you, consider this…

What are the steps of calculating free cash flow?

1. Obtain the cash flow statement of the company

The cash flow statement is filled with a plethora of information. So, your first step would be obtaining the statement. Please make sure that when calculating free cash flow, focus should be on Capital Expenditures and Cash from Operating Activities.

2. Proceed with calculation

To calculate free cash flow, the formula – Cash from Operating Activities less Capital Expenditures – is used. There are three ways to do it, looked from three different angles.

  • Free Cash Flow = Sales Revenues – Operating Costs and Taxes – Required Investments in Operating Capital
  • Free Cash Flow = Net Operating Profit After Taxes (NOPAT) – Net investment in operating capital
  • Free Cash Flow = Net Cash Flow From Operations – Capital Expenditures

For explanations on each of the free cash flow formula, click here. Please note that, if done right, the three calculation mentioned above should yield the same figures.

3. Check for consistency

In some cases, 4 years of data in financial statements is enough to determine consistency in free cash flow. However for the best results, 10 years of data should be used.

Businessman is analyzing financial reports

4. Analyse year-to-date performance

Reviewing the data for the past 10 years is a good way to assess free cash flow patterns. But for you to truly determine if performance is healthy, you need to look at the company’s year to date performance (YTD) in the current fiscal year in relation to the past 10 years.

5. Round off analysis by making your assumptions

When you have established that the company has healthy free cash flow, the next step to take is to determine if the company is on the right track to continue producing those kinds of results. Go through the company annual report to see roadmap and strategy for acquiring new sales and work out how costs will be affected. Don’t forget to confirm if there will be new competition and if they are going to take a share of future costs.

The early days of starting your own business can be the most difficult. With half of all UK start-ups failing within the first 5 years of starting operations meaning heading down the road of entrepreneurship, holding the dream of one day being your own boss can be an arduous journey. The risks involved, regardless of the type of business that you might be starting, are huge. However, with big risks come big rewards, making business ownership an extremely attractive prospect.

It isn’t for everyone, as only those who are committed, hard-working and innovative are likely to succeed. So, are you ready to take on the challenge? If so, get started with understanding the numbers.