Net Cash Flow Formula | Step by Step Calculation with Examples

Free cash flow calculations tell how much cash a company is making. It is the net after paying off the other business overheads. In simple words, cash flow allows entrepreneurs to know how much money they have at hand. It indicates a company’s financial health and eligibility to investors.

The amount of cash coming in and going out in receivables and payables is the cash flow of a company. Cash flow analysis determines the liquidity position of a business.

Free cash flow or FCF amounts to the surplus cash that the business or company can make for its stakeholders. FCF is to enterprises what savings are for households.

An investor needs to look into the FCF of a company. It is an accurate method to find the profitability of a company than the company’s earnings. Let’s read further.

How does Free Cash Flow work 

Positive FCF indicates the overall health of a business. Companies that have a sound cash flow have enough funds on hand. They can meet their bills with ease every month. A business with increasing cash flow is doing well and might go in for expansions. A company with falling free cash might need to downsize. The reason being less money that remains after paying the bills.  

Investors choose to invest in companies with rising FCF. Such companies show excellent prospects. If investors find a company with higher cash flow, and lower share price, they consider it an opportunity to invest. Or see it suitable for a takeover.

How is Free Cash Flow calculated? 

There are many ways to calculate free cash flow. However, they should all give the same results. All companies do not show the same financial information. Investors and analysts calculate FCF according to the data they have access to. The simple way to calculate FCF is to:

Free Cash Flow (FCF) = Operating Cash Flow – Business Capital Expenditures (Capex)

For example, let us calculate the FCF for the last financial three years for ABCE

First, let us go back to the past years. This will help to make better estimates.

Now, the question is how does one grow FCF for coming years? To avoid confusion, let follow the steps given below  

Step 1 – First, estimate the average FCF (for the last three years)

= 28.7 + 56.99 + 8.78/ 3

= 94.47 / 3

= 31.49 Cr

Now, the query is, why take three years? Look at the example above. The last year’s figure is negative, -8.78 Cr. It is not an exact representation of cash flow. So, it is wise to take average FCF figures. Now, let’s proceed further.

Step 2 - Estimates for future FCF 

While calculating forecasts for the next years, let’s use 18% for the first five years. 

Now, the average cash flow for 2018-19 is 31.49 CR. 

At 18% growth, the cash flow estimates for 2019- 20 are, 

= 31.49 *(1+18%) 

= 5.66 Cr 

The free cash flow estimates for 2020-21 are, 

= 5.66 * (1 + 18%) 

= 6.67 Cr, and so on. 

The above numbers are projections. Predicting FCF means predicting sales and expenses. It also uses business cycles and every point of the business. Well, the forecast of future cash flow is just that- an estimate. 

What factors should investors consider when it comes to FCF? 

Long term investors seek higher exposure to companies with sound improvements in FCF. Such companies tend to report average growth during an economic period while outperforming in a down period. A sustained stream of FCF implies that a company can minimize its liabilities, pay dividends, and use cash for further growth. 

Conclusion

Earnings show the current profitability of a company. On the other hand, the free cash flow signals future growth prospects. Cash allows a company to pursue opportunities to enhance the stakeholders’ value.

Free cash flow reflects the ease with which a business can grow.  The investors get an assurance of a rich dividend. This is the main purpose of cash flow projections.