What is Free Cash Flow?

 

Cash flow statement is a more reliable source than balance sheet and P/L. Businesses pay all its bills and expenses using its positive cash flow. Whatever left for growth and value is free cash flow (FCF).

Let’s me explain FCF using an example Company X.

  1. Company X spent RM 100,000 for advertisement for its products.

  2. It received RM 400,000 from revenue because customers paid for the products.

  3. RM 200,000 (50% of revenue) is spent by the company on utilities, salaries.

  4. RM 400,000 – RM 300,000 = RM 100K left in the bank at the end of the year.

How to calculate the final FCF?

  1. RM400,000 of revenue,

  2. RM300,000 of expenses that required cash,

  3. RM 50,000 of depreciation deduction. (No real cash involved but for tax purposes).

  4.  Taxable income is RM 50,000

  5. 20% of corporate tax for RM 50,000 is RM 10,000.

  6. So, Net income is RM 40,000

  7. But, Net Income is not Free Cash Flow

  8. To calculate the actual free cash flow, use revenue and subtract any cash expenditures and add back depreciation. RM 400K – RM 300K – RM 10,000 = RM 90,000

For Company X, free cash flow would be RM 90,000 even though net income reported to shareholders was RM 40,000. The company use RM 90,000 to grow its company further.

Let’s repeat the last operation.

  1. Company X spent RM 100,000 for advertisement for its products. This time, the company needs to borrow RM 30,000 from bank.

  2. It received RM 400,000 from revenue because customers paid for the products.

  3. RM 200,000 (50% of revenue) is spent by the company on utilities, salaries.

  4. Finance cost is RM 3000. (Assumption)

  5. RM 400,000 – RM 300,000 – RM 3,000 = RM 97K left in the bank at the end of the year.

Again, we deduct another RM 50,000 for depreciation; Taxable income RM 47000. Tax is (RM 47000 x 20% = RM 9400). Net income is RM 37600; free cash flow is RM 87,600

Why did the net profit decrease? The company did not generate enough cash to maintain and grow its earnings. Do you check how much FCF your company is making? My point is, without increasing FCF, a business cannot survive for long. It must keep on depending on borrowings to fund growth.

If Company X makes a Revenue of RM 600,000 due to market monopoly and branding, it will not need to borrow to fund its growth anymore. Remember,growth needs money. And Cash is King.

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One Response to What is Free Cash Flow?

  1. Oh my God, you mad freak! That’s intelligent post.

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