Welcome to professorsavings.com, we teach finance basics. Today we will teach you about understanding free cash flow.
Hi I’m Rayfil Wong. We hope these investment concepts will help you be a better investor.
First, let’s try to understand why we care. Whether you’re a small business owner or a CEO, understanding cash flow is key.
Cash is King. Meaning if you have cash, you are able to expand your staff or buy new equipment so understanding this in the accounting books is key.
Free cash flow can be defined as the cash that a company is able to generate after spending the money required to run or expand its business.
It is calculated by subtracting capital expenditures, the funds that company uses to upgrade its physical assets from operating cash flow minus the cash that company spends on day-to-day expenses. Although this may sound complicated, free cash flow is actually quite simple to calculate.
Let’s look at free cash flow for Professor Savings’ Ice Cream. Professor Savings’ financial statement showed that he earned $200,000 last year.
To calculate his free cash flow, Professor Savings would subtract his change in networking capital for the year – current assets minus current liabilities equaling $15,000; and his capital expenditures – $45,000 for a new ice cream machine. These numbers represent the cash that went out of the business.
Finally, Professor Savings will add back any non-cash charges that reduced his net income such as depreciation or amortization – plus $50,000 + $10,000.
This brings Professor Savings’ free cash flow to $125,000