What is free cash flow?

Free cash flow (definition)

Free cash flow shows if a business is making enough money to maintain or grow itself, while still generating a profit.

Free cash flow is a fairly technical accounting concept that is used mostly by lenders and investors. It’s a way of telling whether a business can afford to grow, or at least maintain its existing performance, while still generating good profits.

Free cash flow formula shows operating cash flow (money from sales) minus upcoming expenses equals free cash flow.

Free cash flow formula.

Why free cash flow matters

A business that can’t continue to generate profit while also paying for required improvements will be seen as a risk. It’s more likely to shrink than to grow. As such, investors will probably avoid it. Lenders will be reluctant to issue new debt to the business for fear they may not get repaid.

What does free cash flow mean for the business owner

Business owners can use free cash flow to decide if their growth plans are viable. If the business can’t generate enough cash to finance planned upgrades and bank a profit, then the owner may need to spend more time setting priorities. They will need to decide which upgrades are most important and defer the others.

How free cash flow differs from cash flow, working capital, and liquidity

Free cash flow is a measure of spending power, similar to cash flow, liquidity, and working capital. Each of these terms has its own complexities, but here’s roughly how they compare:

  • Cash flow refers to the general availability of cash
  • Liquidity shows how easily a business can cover upcoming costs (expressed as a ratio)
  • Working capital shows how much money will be left after covering those upcoming costs
  • Free cash flow is the amount of cash left after making capital investments

See related terms

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This glossary is for small business owners. The definitions are written with their requirements in mind. More detailed definitions can be found in accounting textbooks or from an accounting professional. Xero does not provide accounting, tax, business or legal advice.