Often small start-up businesses do their accounting on a cash basis. A sale is recorded when the cash comes in. Costs are recorded as they are paid. In a cash-based business, increases or decreases in cash are the same as profit or loss. Not surprisingly, this approach is known as cash or cash-based accounting.
Cash-based accounting is a good, simple method when a business is in its infancy, or so long as it stays very small. As a business grows, however, cash-based accounting does not do a good job of matching revenue with costs (remember the matching principle). So nearly every growing business eventually adopts accrual accounting; it gives a more accurate picture of profits for a given period of time. You and your accountant need to determine when it makes sense to switch from cash to accrual.
Although Wall Street probably isn’t watching your company, part of your financial intelligence is understanding the context in which public companies operate. You can learn from the issues they are facing and the measures they are using to evaluate their performance. On that note, let’s look at something called free cash flow.
EBITDA, as we noted earlier, is no longer Wall Street’s favorite measure to watch. Now the hot metric is free cash flow. Some companies have looked at free cash flow for years. Warren Buffett’s Berkshire Hathaway is the bestknown example, though Buffett calls it owner earnings. As Buffett’s term suggests, it’s an important metric for entrepreneurial companies.
How to calculate free cash flow? First, get your cash flow statement. Next, take net cash from operations, and deduct the amount invested in capital equipment, as shown in the investment section of the statement. That’s all there is to it—free cash flow is simply the cash generated by operating the business minus the money invested to keep it running. Once you think about it, it makes perfect sense as a performance measure. If you’re trying to evaluate the cash your company generates, what you really want to know is the cash from the business itself minus the cash required to keep it healthy over the longer term.
Publicly traded companies are not required to disclose free cash flow, but most do report it, especially with the new Wall Street focus on cash. It might have helped us all back in the dot-com craze, when so many new companies had negative operating cash and huge capital investments. Their free cash flow was a big negative number, and their cash needs were covered only because investors were throwing lots of dollars into the pot. Buffett, who was nearly alone back then in relying on free cash flow, never invested in any of those companies. What a surprise!
At any rate, if your company’s free cash flow is healthy and increasing, you know at least the following: