Translating an inspired idea into a robust business plan
003 Defining Free Cash Flow
Profit is not the same as cash generated; this concept is fundamental to anyone involved in business planning. The value of a business is determined by its ability to generate cash, and in particular “free cash flow”. Free cash flow is the cash attributable to the providers of capital for a business. The capital for a business comes from two sources i.e. debt provided by banks or bond holders and equity provided by shareholders. Holders of debt get paid interest out of free cash flow and shareholders receive dividends and any cash retained in the business increases shareholder funds.
Profit is not the same as free cash flow for a number of reasons:
Capital expenditure or “capex” is not recorded in the profit & loss account but it appears in the cash flow statement as a cash outflow. For a business which requires a significant investment in infrastructure e.g. building a telecoms network, in the early years of the business cash flow is dominated by capex. The business may be profitable but cash flow negative.
Depreciation and amortisation, i.e. the charge made in the profit & loss account for the use of a fixed asset, is only an accounting entry in the profit & loss account, but does not result in a cash outflow.
There are differences in the timing of a sale made and the cash received. A sale is recorded and shows up as revenue in the profit & loss account at the time of issuing the invoice, but the invoice may get paid several months later while expenses such as salaries have to be paid for in cash. That is to say the business has to invest in “working capital”. For a growing business the funding of working capital, for example in form of debtors or stock, can absorb a substantial amount of cash. If there is insufficient cash, the business becomes insolvent although it may be profitable. This is also referred to as “over trading”. Many businesses fail not because they are not profitable, but because they run out of cash.
For a fairly stable business whose working capital does not change much, a proxy for free cash flow is EBITDA (Earnings before Interest, Tax Depreciation, and Amortisation) minus capex minus cash taxes. When comparing companies, EBITDA minus capex is also a useful metric.