Have You Got Free Cash Flow?
by Anthony Nassar

As an entrepreneur, you're constantly reminded that cash is king. A thorough understanding of your cash flow, current and projected, is not just a necessity. It’s a matter of survival. And while it's critically important that you know what your start-up’s cash balance is at all times, it's equally important that you fully grasp the process of computing where your cash is coming from (sources of funds) and where it’s going (uses of funds). Such a process enables you to 1) get a handle on what happened to your cash when analyzing historical financial data, and 2) derive your cash flow projections when developing your financial plan. Unfortunately, this exercise is not always trivial for those entrepreneurs who have limited knowledge of financial accounting.

1. Your starting point is the Net Income figure from your historical or projected income statement for the period you are interested in analyzing (month, quarter, six months, etc…)
    
2. The ruling formula of this exercise is the one that governs balance sheets, i.e. Assets = Liabilities + Equity
    
3. You need two balance sheet snapshots to perform the computation. The first snapshot should be one day prior to the start of the period being analyzed. The second snapshot is at the end of that period. For example, if your period is January 1, 2005 through December 31, 2005, you would use one balance sheet as of December 31, 2004 and one as of December 31, 2005.

   The financial model in this example was developed using the accrual method of accounting. The period contemplated in this exercise is January 1, 2005 through December 31, 2005. Net Loss for that period is $6,390,000 and depreciation is $91,583. The company raises $12M in a Series B Preferred Stock transaction in 2005. Qualifying transaction costs associated with the financing round, such as legal expenses, are $150,000, leaving $11,850,000 in net cash proceeds from the financing transaction.

   The first step is to take the two balance sheets as of December 31, 2004 and December 31, 2005 and compute the differences between every line item as shown below.

   

   As you can see, the governing formula of the balance sheet (Assets = Liabilities + Equity) is preserved in the column labeled “Difference”.

   In order to arrive at the statement of cash flows, which details the sources and uses of funds, you simply take the figures from the “Difference” column, other than “Cash and cash equivalents” and “Retained earnings”. You will need to change the sign of those figures from the “Difference” column on the asset side of the equation, as an increase in an asset account will correspond to a decrease in cash flow, and a decrease in an asset account will correspond to an increase in cash flow. You then group the resulting sign-adjusted figures into 1 of the following 3 categories:
    

   1. Cash Flow from Operating Activities
   2. Cash Flow from Investing Activities
   3. Cash Flow from Financing Activities

   So how does one do the grouping?

   Based on the line items in this example, we have the following breakdown:
    

   1. Net Loss, Depreciation, and account differences for Accounts receivable, Prepaid expenses, Deposits, Other assets, Accounts payable and Accrued expenses fall under “Cash Flow from Operating Activities" because all these accounts pertain to the operations of the company.
       
   2. The difference figure from Property and equipment falls under “Cash Flow from Investing Activities" because it pertains to the activity of investing in fixed assets. However, the figure needs to be adjusted to reflect the increase or decrease in Property and equipment, excluding depreciation. In this case, the company purchased $181,000 worth of Property and equipment during the period. The period depreciation was $91,583 and the Net property and equipment figure in the “Difference” column is $89,417.
       
   3. Finally, the short-term bank loan reimbursement of $100,000, and the net proceeds from the Series B preferred stock financing of $11,850,000 fall under “Cash flow from Financing Activities."

   Having completed all the computations and classifications, we can now look at the resulting report titled “Statement of Cash Flows Projections”, and displayed below:

   

   What do we learn from this report?

   The company would have burnt nearly $6.4M in operating cash in 2005 (the details of the various components of the sources and uses of funds are shown in the statement of cash flows under the section titled “Cash flow from operating activities”). It would also have acquired $181K in additional Property and equipment during that same year, bringing the total cash burn to approximately $6.6M.

   To fund its growth, the company would have raised $11.85M in equity. It would also have eliminated $100K in short-term bank debt, bringing the net cash inflow from financing activities to $11.75M.

   The period ending in December 2005 would result in a net increase in cash of approximately $5.1M, which corresponds to the excess of the proceeds from financing activities over the cash used in operating and investing activities.

   So does this company have any free cash flow? And what is free cash flow anyway?

   Unfortunately, free cash flow is not cash flow that is distributed for free at a philanthropic event. It is simply the cash that is available for future growth and/or for distribution to shareholders, after the company has financed its operations and capital expenditures. In this case, it's a negative $6.6M (-$6,455,403-$181,000). In other words, the company is eating away, in 2005, a good chunk of the cash raised in the financing round. For example, if cash flow from operating activities was $800K instead of a negative $6.6M, then free cash flow would have been $619K (after subtracting $181K for the acquisition of fixed assets) - clearly a healthier financial picture.

   Positive free cash flow is typically non-existent in the life of early-stage start-ups, as they thrive to build their team, develop new products and take them to market. However, as the venture matures, it must aim to produce a substantial free cash flow in preparation of an anticipated exit strategy. Free cash flow is very important to investors because it provides a measure of a company’s ability to generate cash for distribution to shareholders as dividends, and/or pursue new business opportunities. You’ll even see it as one of the financial parameters in the Key Statistics page for publicly traded companies on Yahoo! Finance. So make sure you are cognizant of this metric. It’s important to your investors, and therefore to you as an entrepreneur while your venture develops.

   Finally, I’d like to caution you that this article does not cover many accounting complexities and other aspects encountered in cash flow statements and free cash flow computations. Examples are inventories, dividends, tax adjustments for stock options, deferred tax benefits, etc… Please consult with a qualified financial professional when putting together these types of computations and reports for your company.