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The purpose of any company, beyond being profitable and sustainable over time, is to increase its financial valuation through market capitalization. For this purpose, a series of accounting tools are needed to make this type of measurement possible, and one of the most widely used is the one that analyzes what we will understand as free cash flow.

That said, in the following article we will discuss what free cash flow is, how it is calculated, its usefulness and importance, as well as other interesting facts.

Free cash flow = free cash flow

Free cash flow comes from the English locution free cash flow, which can be translated as free cash flow, so both notions mean exactly the same thing. The truth is that free cash flow, which is a financial formula used to protect companies from any kind of economic deficit, is used by most businesses that aspire to position themselves in their branch.

What is free cash flow: definition

Free cash flow is defined as the total income and expenses of a business over a given period of time. In general terms, it measures how the total cash flow behaves, its intrinsic and extrinsic circulation. This calculation, moreover, is vital to make any kind of financial evaluation in your business.

In other words, free cash flow represents the amount of cash or dividends remaining to a company after all operational deductions, such as the purchase of assets, stock restoration, payment to suppliers or administrative expenses, including payments to personnel.

Free cash flow vs. operating or operating cash flow

It is important to note that free cash flow should not be confused with operating cash flow. Unlike the former, the latter refers to the amount of working capital that responds solely to the operation or functioning of the business and which is also free of deductions for interest payments, exceptional payments, etc.

In summary, it should be noted that the operating cash flow is obtained after subtracting all the expenses derived from the operation of the company from the income originated by the same.

How free cash flow is calculated

To determine the free cash flow, a formula that reveals the extent of a company's capital, it is necessary to implement an operation that is divided into three steps. The first reveals the gross operating margin, the second the net profit, and the last the free cash flow.

As such, the first calculation would be as follows:

After knowing the gross operating margin, the next step is to find out what the company's gross profit is, which is necessary to determine the net profit. To achieve this, it is necessary to take into account the depreciation of the company's assets and their technological obsolescence or obsolescence:

From the gross profit we must calculate the net profit. To do this, we must subtract from the gross profit all the tax expenses that the company, by law, is obliged to pay.

Now, the time has come to find out what is the amount that represents the operating fund needs or the amount of capital required to cover the total investments that the business entity in question requires to remain in operation. These operating fund needs are obtained by following this simple formula:

If you are wondering what inventory is, it is nothing more than the total investment volume accumulated by the stock of products offered by your business. Customer receivables is the amount of money you expect to receive from defaulters. Cash, on the other hand, refers to the total liquidity available to the company. Lastly, the spontaneous liabilities include the total of the company's debts, such as payroll payments or payments to suppliers, which are interest-free repayments.

Now, to calculate the free cash flow, it will be necessary to do the following:

With this formula you will have the free cash flow that your business needs. Below, we explain a little about its usefulness, importance and other important aspects to consider.

Usefulness of free cash flow

Broadly speaking, we can segment the usefulness of free cash flow into two sections:

• The first, points out to us that free cash flow is essential to analyze the financial situation of the company. As they say, numbers do not lie, and with the result of this formula it is possible to know if a business produces less than expected, what was expected or more than expected. In fact, a free cash flow with satisfactory figures affects all the company's financing margins.

• Second, it tells us that free cash flow is absolutely necessary to perform any type of financial valuation, whether for a short period of time, over time, or even in the future as a speculative projection in relation to its own market.

Importance of free cash flow

Free cash flow is one of the most useful accounting tools you can use to measure the financial health of your company. It is, as we have intuited, a sure method to know the strengths and weaknesses of the company, to know what are its possibilities of growth or to obtain, in case you aspire to grow in your field, financing from traditional banks.

As we can see, the importance of a positive free cash flow lies in the fact that it represents the financial solvency of the business and every company that aspires to transcend in time must consider its use indispensable. This is because it influences the planning, projection and deployment of business strategies that seek to capitalize on better dividends to lighten not only fixed expenses, but also to be prepared for any unforeseen event.

Potential problems related to free cash flow

The maxims of economics, since they often depend on human action, are prone to failure. Therefore, when valuing a company, it is not always entirely positive to trust that cash flows will only increase over time.

It is therefore important to accept that a company's cash flow is fluctuating and may also be tied to a number of external conditions that are difficult for the investor to control. Faced with these eventualities, the important thing is to be prepared for difficult times, protecting capital in good times rather than squandering it.

Remember that accounting valuation systems are tied to what we can call the good or bad decisions of a business manager. A healthy cash flow must be taken care of to the extreme, since the growth of a company is fixed on the basis of all the intelligent investments that its manager can make.

Tips to improve free cash flow

Within this accounting process, it is crucial to take into account the following tips to avoid any risk of alarm that jeopardizes the good state of your business entity in terms of finances:

• Digitize operations: The use of business management programs such as the one offered by AgendaPro, is becoming more essential every day to streamline the recording of payments and collections typical of any company. This, as suspected, saves a lot of time that can be used for other tasks.

• Hire the right people: Finances are not a matter that can be handled by just anyone. You must have an expert in the area, a professional who can guarantee a positive cash flow.

• Define a viable financial strategy: Establish both real goals and a well-structured action plan to meet your objectives. This point is also very important if your goal is to attract potential investors.

• Don't neglect the relationship with your suppliers: Cultivating a positive relationship with those in charge of supplies can help you to best solve any unforeseen event that may arise and that, if not addressed in time, may cause a crack in your free cash flow.

In conclusion, it is important to understand that the free cash flow analysis is a fundamental piece for any company that wishes to calculate its own value. It is also useful to define and project its growth possibilities, and not only in the multiplication of capital, but also as a brand. In addition, it helps us to set a company's share price, which in the long run can translate into an attraction for future investors.

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