How to Calculate Free Cash Flow

Want to know how much cash your business really has to grow? Start with Free Cash Flow. In this video, Steve walks you through how to calculate Free Cash Flow (FCF) step by step—no jargon, just clear, practical guidance.

You’ll learn:

• What Free Cash Flow is and why it matters

• The exact formula to calculate it using real business examples

• How to analyze your FCF to spot trends and make smarter decisions

• Common mistakes to avoid when working with this key metric

Whether you're looking to scale, improve profitability, or just get a better handle on your finances, this video gives you the tools to understand and use Free Cash Flow like a pro.

TRANSCRIPT:

Did you know that 70% of companies that go bankrupt are actually profitable when they close their doors? In this video, I'm gonna walk you through how to compute free cash flow so you can avoid the same trap in your business. Let's start off with the income statement. Now look, I'm gonna keep things really simple here and abbreviate, so just follow along with me.

I'm not gonna get all nerdy with you because I want you to grasp these fundamental concepts as it pertains to free cash flow. So let's start off with revenue. This is where the income statement begins.

Revenue represents your top line, or in other words, the sales of your products and services. Every time you sell a product and service, it hits here on the top line under revenue. Underneath revenue, we have COGS, also known as cost of goods sold, or cost of revenue.

This represents your indirect and direct cost associated with producing your products and services. In other words, material cost, direct labor cost, if you use subcontractors, that would hit cost of goods sold, equipment maintenance, anything related to delivering your products and services to the end user are gonna be up here in cost of goods sold. Now here's just a side note.

When I'm working with companies and I'm looking at their financial statements, too often they have costs that should be up in cost of goods sold down below in operating expenses. So it's really important to put all the direct and indirect costs related to producing your revenue up here because otherwise your gross margin, which is next, is going to be off. I'm gonna abbreviate here GM gross margin, also known as gross profit, but this is the amount of profit or margin you make after setting a price for your products and services, selling those out in the market, and then incurring the cost associated with producing that revenue.

You're left with gross margin here, gross profit. Now sometimes I'll talk with business leaders and they'll say, oh yeah, my business, we make 30 to 40% profit. Unless they're Google or some other company with some superior competitive advantage, it's probably very unlikely that they're earning a bottom line profit of that amount.

Instead, I'm sure they're referring to gross margin. So don't get those confused and make sure you understand the difference between gross margin and net margin, which we'll get down to here in a minute. So we have gross margin, gross profit.

Then we have to account for OPEX. OPEX is just a cool way of saying operating expenses, also known as overhead or SGNA, selling general and administrative expenses. All these costs hit here.

Here's some examples. General and administrative payroll, that's gonna be a big one. Professional fees, taxes and insurance, sales and marketing, occupancy expenses such as rent and utilities.

Everything related to running the business is gonna hit OPEX. So we have revenue, cost of goods sold, which then gives us gross margin. We deduct OPEX and we'll end up with EBITDA.

Now, maybe you've heard this term before. It's just a fancy way of saying profit. It stands for earnings before interest, tax, depreciation and amortization.

Let me break this down for you. You may wonder, why are we excluding interest? Because when we're computing free cash flow, ultimately we're trying to figure out how much cash is available in the business after paying all the bills and everything else to pay back investors, to pay off debt or to reinvest in the business. In other words, we want to ignore the capital structure of the company.

And the capital structure ultimately will dictate the amount of interest a business will earn or the amount of interest it will pay. So since we're trying to compute free cash flow, the amount of money available to capital providers and to reinvest in the business, we're gonna exclude it in the free cash flow calculation.

Now, if you're an accounting nerd like me, okay, I'm an accounting nerd as well, you may be wondering, okay, Steve, what about other income and other expense? We're gonna exclude that in this calculation of free cash flow.

There are some other nuances here as well. We're just staying high level because I want you to understand free cash flow and not get lost in the weeds. So let's keep going.

We have earnings before interest. I told you why we're excluding interest. We have taxes. We don't wanna get there yet. There's some other things we have to account for. And then we have depreciation and amortization, the D and the A. Now, we have to take out depreciation and amortization in order to get to our next line item, which is EBIT, which stands for earnings before interest and tax.

Now, don't let big fancy words like depreciation and amortization confuse you. Here's the deal. When you go buy a piece of equipment, property, plant, or equipment, okay, most of those assets you can write off over a period of time.

Now, according to GAAP, Generally Accepted Accounting Principles, or IFRS if you're outside of the United States, International Financial Reporting Standards, they don't want you to record that property, plant, and equipment expenditure up here in operating expense in one given year because otherwise your financials aren't going to represent the true economic reality that they're trying to capture. So that's why you don't record the purchase of property, plant, and equipment up here in OPEX.

Instead, you record it on the balance sheet. That's called capitalizing an asset. And then you depreciate it. In other words, you write off a certain portion of it over its useful life.

So let's say I buy a tractor and it's $50,000. Instead of recording it as a $50,000 hit to my income statement in one year, I'm gonna record it on the balance sheet. And then every year, let's say it lasts for five years, I'll record 10,000, 10,000, 10,000, 10,000 until the asset is depleted and there's zero salvage value.

So that's depreciation and amortization. You're writing off your property, plant, and equipment each year over its useful life. Depreciation is for tangible assets.

Amortization is the same thing. It's just for intangible assets, such as if you're amortizing a patent, a customer list, a piece of software, something intangible that you can't touch and feel.

All right, so that's depreciation and amortization. Like I said, don't make it overly complicated here because you may be thinking, well, what about section 179 where you can depreciate an entire asset in a given year? Okay, yes, that's for tax purposes, but we're talking about finance here, not accounting. And there's a difference because we're trying to get down to free cash flow to make strategic decisions on behalf of the company to maximize value.

Instead of worrying about all the accounting guidance and compliance, we're not getting into that here in this video.

So let's just do a recap. Revenue, the sales of the company, the cost to produce that revenue, gross margin, op-ex. We end up with EBITDA.

We take out depreciation and amortization to write off our assets. Then we end up with earnings before interest and tax. Now, fortunately or unfortunately, we pay taxes and then we are left with net operating profit after tax.

Now, this is where most organizations stop is that net operating profit after tax. And I'm computing operating profit because I just wanna consider the free cash flow that is generated from normal operations. That's why I'm excluding other income and other expenses because those items aren't a part of normal daily operations of the business.

Okay, so I don't wanna skew the numbers here. So for example, you may have other income from a PPP loan or you may sell a piece of equipment that skews your numbers for the year. We don't want that to mess up our free cash flow calculation because I'm trying to see is the business healthy and is it generating a sufficient amount of free cash flow based on its strategy and based on its operations and everything else.

I'm trying to evaluate the performance of the business in other words. Net operating profit after tax. Most leaders stop here, they celebrate, they say, yes, we're doing so great.

Look at our bottom line. It's so healthy. We have so much profit.

And then 70% of companies that file for bankruptcy, they have profits and it's like, what the heck? How did that even happen? How can a company earn profits and then go bankrupt? It doesn't mean if you're profitable, you're gonna go bankrupt.

It means that when you file for bankruptcy, you can still show profits on your financial statement. So you can totally trick yourself and your team into believing that the company is performing well when in fact, your line of credit is growing and you're running out of cash.

You may know what I'm talking about. If it's tough for you to cover payroll on a regular basis, if you're not paying your bills and your accounts payable is climbing, it's because there's this disparity between profits and cash flow.

All right, so let me get you down to free cash flow here. We're almost there. We have net operating profit after tax. We pay tax and we have money left over, but we need to add back depreciation and amortization.

I'm gonna put a plus here. We're adding it back because remember, it's not a true cash outflow to the business. We're just accounting for it up here for tax purposes.

We're writing off that asset. But if we don't add it back, then we're gonna be miscounting and miscalculating free cash flow.

So I add it back here, and then I have to account for plus or minus changes. I'll do a little triangle in working capital. That does not stand for water closet. That is working capital.

Essentially, working capital is the difference between your current assets and current liabilities. In other words, to simplify it, think about your current assets. Typically, your biggest account balances are found in accounts receivable, the amount of cash your customers owe you, and inventory.

And from a current liability standpoint, the biggest balance is in accounts payable, the amount of money that you owe your vendors. Now, I know I'm generalizing things and may be different for your business, but that's what working capital is from a high level. It's your current assets minus your current liabilities from period to period, not just at a given point in time.

You can't just go to your balance sheet and look at your current assets and current liabilities and put that in here as a number. It has to be the change from one period to the next. That's how you compute your change in working capital.

It's shown on the statement of cash flows as well if you want a shortcut to getting there. Okay, then we have capital expenditures, which I'll just abbreviate as CapEx. Don't confuse that with OpEx.

Capital expenditures, remember, is your investment in property, plant, and equipment. Then after we compute CapEx, I'm just gonna draw an arrow up here because I'm running out of room, we end up with free cash flow, abbreviated as FCF.

That is how you compute free cash flow from the income statement combined with some items from the balance sheet. Remember, we were recording changes in working capital. We're taking CapEx as a change from period over period in your property, plant, equipment, your additions. That's how you compute free cash flow.

This is super critical to pay attention to in your business because if you ignore free cash flow, you can kill your business.

Let me explain something else. Most managers focus their time up here in gross margin. Okay, they're managing the business, they're watching pricing, they're managing labor, material inputs, and they're measuring gross profit. This is where managers live.

Then when it comes to business leaders, they're focusing mostly all the way down to this area right here. This is where most leaders focus. Like I said, down to net operating profit after tax. Their budget, their forecast is all built on net income.

Usually they don't look at the balance sheet, they ignore the statement of cash flows oftentimes, and they're just focusing on revenue, expenses, and ultimately profit.

But my challenge for you is to focus on all this, but most importantly, free cash flow. This is where strategic leaders focus their attention.

And it's not about just paying attention to the numbers and then making short-term moves to increase profits in the near term to ultimately impact free cash flow. Instead, it's about having a strategy for your business.

So you can make a set of interrelated choices about where your company will compete, how they will compete, and ultimately how they will win. And all of those strategic choices combine to drive all of these line items in your business.

And that's how strategy and finance come together to maximize value.

And I can tell you, firm value is ultimately driven by free cash flow in the business. Not by revenue, not by profit, even though oftentimes in the marketplace, valuations get out of whack. Some companies are trading at a multiple of revenue or a multiple of profit.

But at the end of the day, like Warren Buffett said, who is one of the most successful investors out there in the world, he has billions of dollars to prove it. He says intrinsic value, or the value of a company, is the discounted value of all the future cash that the business will produce over its remaining useful life.

And if you think about it quite simply, in business, you're putting money into an investment because you want money back. You put cash in, you want cash back.

You don't want revenue, right? Because revenue doesn't tell you anything about free cash flow. You could have a ton of revenue, but no cash. And profit, like I said, profit doesn't tell you anything because you have to account for working capital and CapEx down below.

And this ties up your money. This ties up your cash. And it can kill your company if you're not paying attention to it.

So it's all about free cash flow. And that's what I wanted to walk you through today so you can understand exactly how to get there.

Now, one last bit of advice. This has helped me in my business and in the businesses that I work with. I recommend assigning each of these line items to somebody in your organization. Assign ownership and accountability to them so they have to pay attention to and manage revenue or cost of goods sold or OpEx or working capital, whatever it may be.

But when you assign ownership to these line items, now everybody's gonna be paying attention to the numbers and they'll understand what their role is in driving greater free cash flow.

Remember, what gets measured gets managed. And it's not about what you expect, it's about what you inspect. And that's really critical to driving high operational and financial performance.

If you got value out of this video, can I get a yes in the comments box? Also, I'd love to hear your feedback, so drop that down below. And until next episode, take care of yourself.

Cheers.