Free cash flow is simply how much money a company has leftover after paying all the expenses of staying in business. That means it tells business owners how much they still need to earn from their business to stay profitable. Many people don’t pay much attention to their free cash flow numbers. They assume their money is running out and they’re losing money.
The reality is that cash flow numbers are an accurate measure of your company’s profitability. However, these numbers don’t include your customers’ or the impact of your normal business activities on your bottom line. Business owners ignore this information, because they think they already paid for everything they need to earn. They fail to realize that capital expenditures, such as rent, payroll, supplies and advertising, create a large portion of their profits.
Your cash flow statement should show the gross profits and net profits minus capital expenditures. The gross profit is your total income from all operating activities, while the net profit is an estimate of your sales less any direct expense, like payroll. It is necessary to calculate both of these figures because they are important to investors who want to know how much they can get from your company. Investors use these numbers to determine whether or not you are a good investment. So understanding how your profits are calculated is crucial to keeping your business profitable.
Some investors are wary of capital expenditures and want to see immediate cash from your company. They might be willing to fund your business depending on the initial investment. But if they don’t see an increase in sales after funding, they won’t invest. And this means that you are losing potential investors every day while funding your business. As long as you continue to operate your business without additional capital, your cash flow will eventually die.
The main reason that your cash flows will die off quickly if you continue to invest without a plan is because you will only be using 70% of your profits. You see, the investors who funded your business are the ones making the money. So if you are not making any money, they are not getting paid! If you are still making money, then you are using more of your profit in your capital expenditures than your actual profits. When this happens, the company is not generating enough cash flows to meet its expenses, and it soon runs out of money to do so. When this happens, your company might have to close its doors.
So how do you maintain the level of cash flows that you need to pay your expenses and keep your company operational? The answer is to add more working capital to your balance sheet. By working capital, we mean any current assets that you have that generate a cash return. These include new equipment bought to increase your production capabilities; accounts receivable that you get from clients who purchase your goods; and any raw materials you receive from suppliers that sell to you.
Most small businesses will only add a few working capital items to their balance sheet each year. That’s because most businesses don’t earn enough dividends to support significant increases in their cash flows. That’s why you rarely see any discussion about dividends in your annual income statement.
How can you use the operating cash flow calculation to improve your core business activities? Well, by making all of your expenses and receipts (which include inventory and utility bills) at least equal the cost of doing business you will see an increase in your gross profit margin. This means that you should also include an estimate of your investment return on equity in your annual income statement. Also consider any rent collections and depreciation for property and tangible assets. The formula for calculating your core operating cash flow is: Gross Profit = Actual Expenses + Core Business Activities Expended + Core Business Activity Estimates + Core Business Activity Indications + reinvestment Return on Equity. Please see the below article titled “Free Cash Flow” for more information on calculating this vital key ratio.