What is free cash flow (FCF)? Formula and calculation

The term free cash flow gets thrown around a lot in the startup world, especially when it comes to finding business partners or investors. Everyone seems hyper focused on this metric, but what does it mean? And why does it matter?

TLDR: In a nutshell, free cash flow indicates your business’s financial health. It measures your profitability and shows how much extra cash you have left over to invest in growing your startup (or paying dividends to shareholders).

Obviously, you came here for a more detailed explanation, but that’s a small taste of what’s to come. We have answers to all your free cash flow questions below—including what it is, why it matters, and the formula(s) to help you calculate it.

Free cash flow definition

Free cash flow (FCF) measures your startup’s remaining cash after accounting for necessary day-to-day operating expenses. It’s a significant indicator of the financial health of your business—more money left over means you’ve got your ducks in a row and aren’t scrabbling to make ends meet.

You can imagine why business partners and potential investors care about free cash flow. A positive cash flow proves your revenue exceeds your expenses, which means you have money left over to invest in growing your startup or compensating owners and shareholders.

Now, negative cash flow isn’t necessarily a vibrant red flag. Yes, it indicates that you haven’t reached profitability yet, but it doesn’t mean you’re not on the right path.

Right from the get-go, you’ll likely be in a negative cash flow statement for a period of time. That’s normal. It takes money to make money, and you’ll likely need to invest extra cash into building your startup before you start earning paying customers and recurring revenue.

However, the problem comes when you stay in a negative cash flow state and can’t find your way to profitability. Investors want to know they’ll see a return on their investment, and that likelihood is diminished when your startup is struggling to meet day-to-day expenses.

Free cash flow formula: How to calculate

You won’t find free cash flow on any of your traditional financial statements, and it’s not a required metric to report. Thus, there’s no regulated free cash formula to follow when calculating it. However, there are a few best practices and standard approaches to perform your free cash flow calculation.

1. Free cash flow = Operating Cash Flow - Capital Expenditures
2. Free cash flow = Sales Revenue - Operating Costs - Necessary Investments in Operating Capital
3. Free cash flow = Net Operating Profit (After Taxes) - Net Investment in Operating Capital

Having a variety of formulas helps you calculate free cash flow even if you don’t have every metric you want. Investors and analysts will use the most appropriate free cash flow formula to investigate your startup’s health. You can also use these formulas to monitor the health of your competitors and see how you measure up.

Why is free cash flow important during an economic downturn?

Free cash flow isn’t a new metric—investors have been looking at this measurement (in one form or another) forever. However, it becomes increasingly important during times of economic uncertainty, such as during a downturn or recession.

Investors want to know that your startup is equipped to weather the storm. Ideally, they don’t want you just to survive—they want you to thrive. Yet, if you can’t maintain healthy, positive free cash flow outside of an economic downturn, your chances of preserving it during uncertainty are significantly reduced.

Importantly for investors, the inverse is also true. Building and maintaining a positive free cash flow during an economic recession will build faith and trust in investors and analysts. They’ll have high expectations for your startup, especially as the economy emerges from a downturn and begins to experience growth.

How does a recession impact your startup?

Not every business gets hit hard by an economic downturn—some can even profit from it. It all depends on your geographic location, industry, products, and customers.

Here are a few ways a recession can impact your startup:

• Fewer financing opportunities: Some hesitant lenders and investors might be less willing to approve loans and investments during a recession. There are higher risks for them, especially if you don’t have the free cash flow to back up your business.
• Slower cash flow: You’ll likely spend more time chasing down invoices and late payments, making it harder to make your own on-time payments. Business-to-business (B2B) companies can completely lose out on deals if paying customers go out of business.
• Less spending: Consumers and businesses spend less and save more during a recession (which does have a short-time boost for free cash flow). This means fewer opportunities to sell your goods and services.
• Higher attrition rates: Startups have to make hard decisions, including workforce reductions and benefit cuts, during an economic downturn. Remaining employees who are change-averse might also look for opportunities elsewhere.
• Decreased marketing budget: Businesses tend to reduce or eliminate their marketing budgets when recessions roll around. A reduction in your marketing and advertising often results in reduced revenue growth.

6 tips to better manage your free cash flow

Free cash flow isn’t some arbitrary, unchanging measure of your startup’s financial health. Instead, the decisions you make today and tomorrow impact this number, and you can have a direct and powerful influence on this metric.

Here are a few practical tips for improving your free cash flow.

1. Monitor your accounts receivable

Money owed to your business isn’t your business’s property yet. You might have already exchanged the good or service, but that money isn’t yours until it lands in your bank account.

Customers often delay payments or even default during economic downturns. They struggle to make money—thus, they struggle to pay you money—therefore, you struggle to pay your bills.

It’s an endless, painful cycle.

If you notice problems with your accounts receivable, make changes to save your bottom line. Here are a few actions you could take:

• Charge customers higher down payments or retainers
• Impose higher (and earlier) penalties on late payments
• Send invoices faster
• Incentivize customers to make early payments
• Send out regular, recurring invoice reminders
• Find an invoice factoring partner

Don’t wait until the problem gets out of hand to make a change.

2. Delay payments to vendors

On the flipside, take your time paying your own startup’s bills. Don’t delay beyond payment terms or incur late-payment penalties, but let your cash sit longer before you spend it.

For example, if you have 30 days to pay an invoice, wait until you’re closer to that 30-day mark to make the payment rather than take care of it immediately.

3. Purchase less inventory

Be strategic about your inventory purchases. If items aren’t moving, don’t keep dumping costs into long-term storage—even if discounts are available for future growth.

Consider offering bundled deals or selling to bulk discounters to clear up your inventory. This could give you a simultaneous bump in revenue and a decrease in expenses.

4. Change your pricing

Review your pricing and see if now is a good time to switch things up. You might try experimenting with new pricing tiers, packaging plans, or even raising your pricing across the board.

You don’t want to alienate your current or future customers with a costly offering. However, strike the sweet spot between increasing your revenue and retaining customers.

If you’re a subscription-based business that hasn’t updated pricing in years, an economic downturn might be the time. It’s a strategy for keeping up with inflation and your own rising expenses.

5. Analyze your business metrics

Keep a close eye on your business metrics to find emerging trends. You might see that a previously underperforming product is now gaining traction, or you may discover a marketing channel has drastically reduced its cost per acquisition.

When you notice these trends, make a plan to capitalize on them. Scale marketing strategies that work and cut underperforming experiments. Invest in products that are selling now, instead of products that sold well pre-recession.

6. Cut unnecessary spending

Examine your costs and cut the extra expenses. Before you start cutting contractors, laying off employees, and decreasing perks and benefits, take a look at other high-spend areas:

• Real estate: Are you using your office space, or have you shifted to a remote work model? Consider letting go of your office lease, and other office perks, if it’s not essential.
• Software: Are you using all of your software licenses? Can you cut subscriptions or downgrade your pricing tiers?
• Employee travel: Consider reducing employee travel (plane tickets, hotel stays, food stipends, etc.) to save costs temporarily. Look for cost-friendly remote ways to invest in team building and employee morale.

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