Why Free Cash Flow Is Important
Free cash flow is the amount of cash a company possess in the bank at any given time after all of its bills and payables are accounted for either on a daily, weekly, monthly, or yearly basis.
Free cash flow is important in the life of a business as it is a good indicator of a company’s strength in the market place, being its ability to pay its bills and use the remaining cash to invest in other growth expansion projects.
Many businesses rely on a bookkeeper or an accountant to inform them of their available free cash flow after-the-fact, meaning they look at the bank balance after they pay their bills, payroll, and any other expenses they have. Although this cash usually is not a lot of money, the majority of businesses do not know what to do with the extra cash in the bank. Normally entrepreneurs either believe the y should save it for the following month’s bills, or believe they can spend it all on extras, (new office furniture, technology upgrades etc).
If you remember when the financial crisis hit, Citigroup, Bank of America, and all of the major banks had to undergo a “Stress Test” to determine the solvency of the banking system given the occurrence of another major financial crisis. This stress test was important as it was the major indicator as to whether the banks would be able to meet their financial obligations (pay their creditors and investors) given another major catastrophic event. Entrepreneurs should view your business in the same way. What if one day sales just started to plummet and you were unable to recover in a short amount of time; what would you do? Would you still be able to stay in business?
In order to properly predict the amount of cash flow you will need for the future, the first step to review your most recent end of the month business bank balance. While theoretically you can choose any day of the month to do your comparison, banks send out an end of the month summary of your bank balance on a certain date. If you have access to online banking, even better, as it allows you to do a line by line comparison of your end of the month summary
Now let’s take a look at that bank balance and work backwards, reviewing the end of month bank balances for the past 6 months. Take note of the difference in your cash balance between your most recent month (let’s call it December) and the previous month (Let’s call it November). Write it down. Next, take note of the ending balance from November compared to October and so on. If the difference in the amounts of the ending bank balance is somewhat consistent from one month to the next, congratulations, you will have an easier time taking predicting, evaluating, and planning for free cash flow. If the difference from month to month varies greatly, then you will have to investigate why the ending balances vary so greatly.
Now we determine how much of that cash is REALLY free. In this case free means that you can use the cash to invest in additional equipment, operations, marketing etc. For this, a conservative and simple approach is always best.
Again, take a look at past twelve months, highlighting the month with the lowest amount of cash at the end. Now divide that amount by twelve and this is the amount of cash that is really FREE, meaning you should use this to make improvements or invest in your business.
*Please note that if any months have generated negative cash flow, you should take a look at first improving your business to create a positive cash flow environment.