I previously invested in public companies on behalf of a major asset management company, and we used free cash flow as a measure of a company’s performance. However whether you’re managing a public company or a private one, cash flow is king.
In simple terms, free cash flow is calculated as follows: cash from operations (found on the cash flow statement) minus capital expenditures. When only the income statement is used to measure performance, companies can mask operating issues and manipulate earnings. Furthermore, the income statement fails to take into account the company’s investment activities, otherwise known as capital expenditures.
When free cash flow is positive, the company has cash left over after it has invested in the business through capital expenditures. When free cash flow is negative, a company is not able to generate sufficient cash to support the business.
Since many small businesses are investing heavily to rapidly grow their businesses, they may not generate free cash flow. Now, if a company is growing revenue at a steady growth rate and managing costs below that growth rate, it can generate healthy margins, which should naturally flow through to cash flow. However, such smooth financial performance is not always apparent. These three strategies may help you increase free cash flow for your firm.
Hire a CFO Focused on Cash Management
Regardless of industry, having a good CFO or finance manager that understands future cash flow can be incredibly helpful. Consider hiring a CFO that knows how to project cash inflows and outflows, including a 12-month forward-looking view on any upcoming capital expenditures. A CFO can focus relentlessly on payables and receivables, which may help you manage the money leaving your company to pay debtors and coming in from customers. CFOs who incorporate weekly or biweekly cash flow dashboards into their company can be beneficial to your company's overall health.
Determine Optimal Capital Structure
One reason that cash flow from operations is often lower than ideal is due to interest expense, which is directly related to a company’s debt obligations. Companies with lower amounts of debt typically have lower interest expenses, and thus have more cash available from operations and higher free cash flow. Remember, it may also be difficult for your company to obtain a loan or line of credit if the company does not generate enough net income to cover the debt payments. As a result, optimizing a company’s debt and equity structure can be beneficial for future financing needs as well.
Manage Capital Expenditures Effectively
You may want to consider calculating capital expenditures as a percentage of revenue. In doing so, management teams can evaluate how much of their sales are being invested back into the business. Consider determining what level is appropriate for your company. If your company has a capex-to-sales ratio of more than 5-10 percent, you may want to evaluate whether some expenditures can be delayed until the following year or if they are worth pursuing at all. While investing in the business is important, you may not want to overinvest because there may be less cash available for future activities.
Effectively managing cash flow is a challenge for many small companies. By hiring the right CFO, obtaining an optimal capital structure and/or investing appropriately for growth, you may be able to generate free cash flow—a performance metric that may influence a company’s valuation and ability to sustain itself over time.
Read more articles on managing money.