Free Cash Flow

Importance of Free Cash Flow

A business is ultimately valued based on the cash flow that the business will generate for its owners. All the efforts, strategies, decisions, and years of work come down to this. While the business owner has a long history, emotional connection, and sense that this is his / her baby, investors and business buyers are purchasing the business for the cash flow that will be generated. Terms such as EBIDTA, Net Income, EBIT, after-tax income, free cash flow, and many others are commonly used to describe this stream of cash flow. It is critical to realize is that what matters most to the business buyer is Free Cash Flow or “FCF”. Free Cash Flow is the amount of money that is available after paying all expenses including debt, interest, preferred shareholders, taxes, capital improvements, and any cash that must be used or left in the business for increases in working capital.

At the end of the day, Free Cash Flow is the money that is available for the owners and shareholders to do whatever they want with it. As Warren Buffet would say “cash is cash and all accounting is up to interpretation.” FCF can be distributed, reinvested in unrequired improvements, set aside in retirement accounts, used for additional debt payments of any other manner the owners want. It is the cash that can be used once all obligations and required reinvestments in the business have been made.

Many times sellers, business brokers, and even CPAs will use other forms of income in their calculations which can result in an overvaluing of the business.

The following formula is used to calculate Free Cash Flow:

Net Income (after paying all expenses including taxes)
+ NonCashExpenses(depreciation, amortization, deferred taxes&Revenue)

• Capital Expenditures

• Additions to Working Capital

• Debt Repayment

• Dividend Payments to Preferred Shareholders

  =Net Cash Flow to Equity Owners

The calculation of Free Cash Flow and any forecasting should be left up to an experienced CPA and is outside the scope of the book. For now just understand that once Free Cash Flow is calculated, the expected return for the risk from all the factors that impact the business and its cash flow will determine the final value of the business.