Free cash flow tracks the money.

It's what you have left over at the end of

the year, or quarter, after you pay all your bills and pay for any new capital
expenditures. It is what you have left over to pay investors. Free cash flow
can be calculated in three different ways. All three are simple calculations.
Here is one free cash flow example calculation. It is a very simple calculation
and a part of cash flow analysis.

Free Cash Flow = Net Cash Flow From Operations - Capital

Expenditures

where Net Cash Flow from Operations comes from the Statement of Cash
Flows and an increase in capital expenditures comes from the balance sheet

If you look at free cash flow across several years of firm data and it is
growing, that usually means that a growth in earnings is on the horizon for
the firm. Firms with growing free cash flows are doing something, or many
somethings, right. They may be enjoying growth in revenue. They may be
efficiently managing their assets. They may be paying down their debt. They
may be reducing their costs.

If free cash flow is declining over a number of time periods, there may be
dark clouds on the horizon for the company. Firms with declining free cash
flow can expect a decline in earnings growth and worse. They may have to
take on increasing levels of debt and may experience declining liquidity.

Keep in mind that free cash flow is not completely immune to accounting
trickery. There is not a regulatory standard set for it so there are a couple of
different ways it can be calculated, though I have given you the most
common way in this article. Items like accounts receivable and accounts
payable can be manipulated regarding when payments are received, made,
and recorded to make free cash flow look larger than it is.

As a small business owner, free cash flow is a statistic you should calculate
regularly. It will let you know how your company is doing and exactly how
much cash you have to work with after all your bills are paid. It indicates if
you can go ahead and expand your firm or if you should wait.

Cash Flows From Operating Activities

Looking at the balance sheets, accounts receivable has increased from

$170,000 to $200,000 for an increase of $30,000. Since that increase
occurred on the asset side of the balance sheet, it is shown as a negative
figure. Why? If the firm extended $30,000 more in credit to its customers,
then it had $30,000 less to use. Likewise, inventory increased by $20,000.
Prepaid expenses decreased by $10,000. A decrease in asset account, a
source of funds to the firm, is a positive number. Cash increased by $35,000
but it is not included in our initial analysis. It will soon become clear why.

Now look at the liabilities section of the balance sheet. Accounts payable
increased by $35,000. Short-term bank loans didn’t change. Accrued
expenses such as taxes and wages decreased by $5,000. Since this is a
decrease in a liability account, it is a use of funds to the firm and a negative
number.

Next is Net Cash Flows from Operating Activities, the summary of the first
section of the Statement of Cash Flows. When you add up the adjustments
to net income and depreciation, you get $150,500. The firm is generating a
positive net cash flow from its operating activities.

Cash Flows From Investing Activities

The next section of the cash flow statement is Cash Flows from Investing
Activities. Usually, this section includes any long-term investments the firm
makes plus any investment in fixed assets, such as plant and equipment.
The firm invested $30,000 more in long-term investments in 2009. That
shows up as a negative number as it was a use of assets. The firm also
spent $100,000 for more plant and equipment.

Next is Net Cash Flows from Investing Activities , the summary of the
second section of the Statement of Cash Flows. It is a negative $130,000
since this was the outlay in 2009.

Cash Flows From Financing Activities

The last section of the cash flow statement is Cash Flows from Financing
Activities. In this case, you have financed your firm with long-term bank
loans that have increased by $50,000. Dividends to investors in the amount
of $65,000 have also been paid, which is a cash outflow and a negative
number. Net Cash Flows from Financing Activities is a negative $10,500.

Net Cash Flows for the Firm

Now, we combine the three sections of the cash flow statement to see where
the firm is from a cash flow perspective. When you sum the net cash flows
from each section you get a positive $10,000. This is the net increase in
cash flows over the year for the business firm. Looking back at the cash
account on the comparative balance sheets, the analysis is correct. Cash has
increased by $10,000 from year to year.

The cash flow statement is one of the three most important financial
statement a business owner uses in cash flow analysis. The concept of cash
flow is different from the concept of profit or net income and the business
owner should think of each in different terms and analyze each from
different perspectives. There are financial ratios that help the business
owner that focus on net profit and those that focus on cash flow.

Cash flow analysis uses ratios that focuses on cash flow and how solvent,
liquid, and viable the company is. Here are the most important cash flow
ratios with their calculations and interpretation.

1. Operating Cash Flow Ratio

The operating cash flow ratio is one of the most important cash flow ratios.
Cash flow is an indication of how money moves into and out of the company
and how you pay your bills.

Operating cash flow relates to cash flows that a company accrues from
operations to its current debt. It measures how liquidity a firm is in the short
run since it relates to current debt and cash flows from operations.

Operating Cash Flows Ratio = Cash Flows From Operations/Current

Liabilities where:

Cash Flows from Operations comes off the Statement of Cash Flows and
Current Liabilities comes off the Balance Sheet

If the Operating Cash Flow Ratio for a company is less than 1.0, the
company is not generating enough cash to pay off its short-term debt which
is a serious situation. It is possible that the firm may not be able to continue
to operate.

2. Price/Cash Flow Ratio

The price to cash flow ratio is often considered a better indication of a
company's value than the price to earnings ratio. It is a really useful ratio for
a company to know, particularly if the company is publicly traded. It
compares the company's share price to the cash flow the company
generates on a per share basis.

Calculate the price/cash flow ratio as follows:

Price/cash flow ratio = Share price/Operating cash flow per share

where:

Share price is usually the closing price of the stock on a particular day and
operating cash flow is taken from the Statement of Cash Flows. Some
business owners use free cash flow in the denominator instead of operating
cash flow.

It should be noted that most analysts still use price/earnings ratio in

valuation analysis.

3. Cash Flow Margin Ratio

The Cash Flow Margin ratio is an important ratio as it expresses the
relationship between cash generated from operations and sales. The
company needs cash to pay dividends, suppliers, service debt, and invest in
new capital assets, so cash is just as important as profit to a business firm.

The Cash Flow Margin ratio measures the ability of a firm to translate sales
into cash. The calculation is:

Cash flow from operating cash flows/Net sales = _____%.

The numerator of the equation comes from the firm's Statement of Cash
Flows. The denominator comes from the Income Statement. The larger the
percentage, the better.
4. Cash Flow from Operations/Average Total Liabilities

Cash flow from Operations/Average total liabilities is a similar ratio to the

commonly-used total debt/total assets ratio. Both measure the solvency of a
company or its ability to pay its debts and keep its head above water. The
former is better, however, as it measures this ability over a period of time
rather than at a point in time.

This ratio is calculated as follows:

Cash flow from Operations/Average Total Liabilities = _______%

where:

cash flow from operations is taken from the Statement of Cash Flows and
average total liabilities is an average of total liabilities from several time
periods of liabilities taken from balance sheets.

The higher the ratio, the better the firm's financial flexibility and its ability to
pay its debts.

5. Current Ratio
The current ratio is the most simple of the cash flow ratios. It tells the
business owner if current assets are sufficient to meet current debt. The
ratio is calculated as follows:

<P>Current Ratio = Current Assets/Current Liabilities = ______X

where:

both terms come from the company's balance sheet. The answer shows how
many times over a company can meet its short-term debt and is a measure
of the firm's liquidity.

6. Quick Ratio (Acid-Test)

The quick ratio, or acid test, is a more specific test of liquidity than the
current ratio. It takes inventory out of the equation and measures the firm's
liquidity if it doesn't have inventory to sell to meet its short-term debt
obligations. If the quick ratio is less than 1.0 times, then it has to sell
inventory to meet short-term debt, which is not a good position for the firm
to be in.

Here is the calculation for the quick ratio:

Quick Ratio = Current Assets - Inventory/Current Liabilities where all
terms are taken off the firm's balance sheet.