A key solvency metric: Free cash flow

In the short term, businesses need liquidity to pay their bills to keep vendors and employees happy. But what about the long term? Businesses need to money to expand operations (and sometimes to pay more dividends to keep shareholders happy). Without free cash flow, a business runs on a treadmill, taking in money and giving it back out again. For a business to grow, they need free cash flow.

MEASURE YOUR SOLVENCY WITH FREE CASH FLOW

There are other ways to measure solvency but I like free cash flow as one of the key metrics to use because it reveals that all-important cash flow number.

So here is how to calculate the free cash flow metric:

Cash from operating activities – capital expenditures – Dividends paid

Here’s how to understand this metric:

  • Cash from operating activities is the money taken in from doing whatever it is your business does — selling your products and services to your customers. (Businesses can also bring money in from investing or financing, so cash from operations measures only the money brought in from the actual selling of whatever it is your business sells; it doesn’t include that “one-off” money you bring in from selling a factory or taking out a loan).
  • Capital expenditures is the money spent to buy the big stuff — often summarized as “property, plant, and equipment” — that a business needs to run its operations. The actual definition is a little fuzzy (it depends on the business; we don’t all need a factory) but in general it’s the stuff that you have to spend a lot of money on, and then amortize and depreciate over more than a one-month period.
  • Dividends paid is money that you pay to shareholders in the company.

You just take the money you get from operations and you subtract the money you spend on property, plant, and equipment, and you also subtract the money you spend on dividends. What’s left over is the money you use to grow your business.

In general, you can use the money in the following two ways:

  • Expansion: Businesses can use free cash flow on more marketing to increase their marketshare or they can use it to enter new markets. They can use the money for research and development to innovate new products and services.
  • Additional shareholder rewards: Businesses can use free cash flow to provide additional dividend payments to shareholders, rewarding those shareholders with more money. As a stockholder and as a business owner, additional dividends are welcome!

So let’s look at some examples:

You’ve got a lemonade stand.

You netted $10.00 in cash from operations. But you spent $5.00 to rent the lawn and a table from your cranky old neighbor, Mr. Farley, whose lawn is way better for a lemonade stand than your home’s lawn. And you also had to pay your mom $1.00 in shareholder dividends because she was kind enough to lend you the lemonade in exchange for for a 10% daily dividend.

So let’s plug the numbers into the calculation:

Here’s the calculation again…

Cash from operating activities – capital expenditures – Dividends paid

We’ll plug in the numbers…

Cash from operating activities: $10.00 – capital expenditures: $5.00 – Dividends paid: $1.00

So the equation looks like this…

$10.00 – $5.00 – $1.00

Which leaves $4.00 as free cash flow. You can use that money to buy higher-end lemonade, to innovate new lemonade recipes, to pay for a wider marketing effort, or to pay your mom a higher dividend.

Let’s look at a real life example of free cash flow. We’ll use an insanely cash-rich company — Apple (APPL) — and we’re using the information from their quarterly cash flow statement (the most recent statement available at the time of this writing), published June 30, 2012.

Again, here is the equation…

Cash from operating activities – capital expenditures – Dividends paid

And we plug in the numbers…

Cash from operating activities: – capital expenditures – Dividends paid

Cash from operating activities: 10,189,000,000 – capital expenditures: 2,056,000,000 – Dividends paid: 0 (they don’t pay dividends)

Cleaning it up a bit…

10,189,000,000 – 2,056,000,000 – 0

So Apple’s free cash flow is: 8,133,000,000. Nice!

Who wouldn’t love to have 8.133 billion to use for expansion???

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