When it comes to measuring the performance of a business, free cash flow margin is one of the best performance indicators available. Specifically, it's a profitability ratio indicator. It shows how well a company is converting sales to cash.
Companies need positive free cash flow to survive and expand. Cash is what allows a business to pay its expenses and purchase assets. Cash flow margin is basically a return of cash on sales. The bigger the margin/ratio, usually the better the return.
Calculating Free Cash Flow Margin
The formula for calculating free cash flow margin is:
Cash Flow Margin = Cash Flows from Operating Activities/Net Sales
Cash Flows from Operating Activities is basically free cash flow. Free cash flow is calculated across a period of time. Let's say 12 months. We can now use the following formula to derive free cash flow:
EBIT x (1 - tax rate)
- change in net working capital
- CAPEX (change in capital expenditures)
= free cash flow
Accounts receivables are included in the above calculation. Because we are calculating over a period of time (12 months), there will be beginning and ending accounts receivable figures. For example:
Beginning = $1000
Ending = $3000
We can see that accounts receivables have increased by $2000. This amount will be subtracted in the above free cash flow formula. When one of the formula items is subtracted, it's a use of cash. In this case, accounts receivables are using $2000 in cash.
You might wonder what exactly that means. We know that accounts receivables will eventually turn into cash. But until that happens, we don't call the amount cash. We call it accounts receivables outstanding. It's real cash that we don't have access to. That's why accounts receivables
Let's look at the flip side. Accounts payable is also used in the free cash flow formula. For the same period, accounts payable looks like this:
We can see that accounts payable
Net Income: $75000
Accounts Receivables: ($2000)
Accounts Payable: $1500
Free Cash Flow: $59500
Sales: $925,000 (during same period)
We now have the numbers needed to calculate free cash flow margin. These are:
- Free cash flow
Free Cash Flow Margin: 59500/925000 = 6.4%.
We can see that free cash flow margin is 6.4%. Why exactly is that useful? Taking this number across multiple periods will provide insight into the performance of free cash flow margin. The above calculation was done off a 12 month period. Let's assume we've been calculating this value every year for the last five years. The following is what we have:
Year 1: 3%
Year 2: 4.5%
Year 3: 4.8%
Year 4: 5.5%
Year 5: 6.4%
We can now clearly see a trend of increasing free cash flow margin. This points to an increased efficiency in the use of sales operations to generate free cash flow.
Valuing A Company Based on Free Cash Flows and WACC
When valuing a company, we can use free cash flow to the firm (FCF) and WACC (weight average cost of capital). This formula divides free cash flow by WACC times growth rate. The formula looks like this:
value of business = FCFF / (WACC - g)
Where g is the growth rate of FCFF. Often in this formula, we are using FCFF for the next year. In other words, a projection of FCFF. Let's use some real numbers to determine the value of the above business.
- FCFF = $59500.
- FCFF next year is the expected growth rate. Using our years 1 through 5, we expect an FCF growth rate of roughly 7.3% next year.
- Return on capital is 9.5%.
59500 x (1 + .095) / (.095 - .073) = $62152 / 0.022 = $2,825,091
Using this simple calculation, we have a company valued at $2.825M.
Impact of Accounts Receivables On Company Value
We should keep in mind the impact of accounts receivable on free cash flow. If A/R had accumulated during the same period, increasing to $10000, this would have a left a change of $9000 instead of $2000. But what effect does this have on company valuation?
Let's run the updated numbers:
Net Income: $75000
Accounts Receivables: ($9000)
Accounts Payable: $1500
Free Cash Flow: $52500
We can now plug this into our valuation formula:
52500 x (1 + .095) / (.095 - .073) = $62152 / 0.022 = $2,613,068
This is a difference of $212,023 or a decrease of about 7.5%. Quite an impact just due to an increase in accounts receivables.
In this article, we've seen how to fully calculate free cash flow margin along with how to use it in finding the value of a company. Finally, we considered the impact of