Net Free Cash-Flow Approach (Take Advantage of Warren Buffett's Secret Weapon)
In the world of business and investing, few names carry as much weight as Warren Buffett. He has amassed a fortune through astute investments and sound business principles. One of his most powerful tools for evaluating a company’s health and potential is the Net Free Cash-Flow (NFCF) approach.
Our four in this post it to help breakdown this concept for business owners who might be interested in using it as a measure of success for their businesses. Understanding and applying this concept can be a game-changer, it can provide a clear measure of financial success based on how much money (profit) can be taken out of the business regularly.
Understanding Net Free Cash-Flow
Net Free Cash-Flow represents the amount of cash generated by a business after accounting for all operating expenses, capital expenditures, and other necessary expenditures. Unlike net income, which can be influenced by non-cash items like depreciation and amortization, net free cash flow (NFCF) focuses solely on the actual cash available to the owner. This metric is important because it reflects the true profitability and financial health of a business.
Why Net Free Cash-Flow Matters
Liquidity and Flexibility: NFCF provides a clear picture of the cash available to reinvest in the business or elsewhere, pay down debt, or distribute to shareholders (your investors). It ensures you have the liquidity to handle unforeseen expenses or take advantage of new opportunities.
True Profitability: By focusing on cash flow rather than accounting profits, NFCF strips away the noise and shows how much money the business is actually generating. This helps in making more informed decisions about growth, investment, and cost management.
Owner's Earnings: For business owners, NFCF is a direct indicator of the money that can be taken out of the business without harming its operations. This is the profit that can be used for personal expenses, further investments, or savings.
Calculating Net Free Cash-Flow
To calculate Net Free Cash Flow, follow these steps:
Start with Operating Cash Flow (OCF): This figure is typically found on the cash flow statement of your business and represents the cash generated from core business operations.
Subtract Capital Expenditures (CapEx): These are funds used by the business to acquire, upgrade, and maintain physical assets such as property, industrial buildings, or equipment. CapEx is essential for sustaining or expanding business operations.
Adjust for Changes in Working Capital: Working capital includes accounts receivable, inventory, and accounts payable. Changes in these items can affect the cash available in the short term.
The formula looks like this:
NFCF = Operating Cash Flow - Capital Expenditures ± Changes in Working Capital
Formula Breakdown:
Operating Cash Flow: Start with the cash generated from operating activities. This is the primary source of cash for most businesses and indicates the cash flow generated from the company’s regular, core business activities.
Minus Capital Expenditures: Subtract the capital expenditures. These are investments in long-term assets needed to maintain or grow the business. While necessary, these expenditures reduce the cash available in the short term.
Plus or Minus Changes in Working Capital: Adjust for changes in working capital. If the working capital has increased (indicating more cash is tied up in the business), subtract this amount. If the working capital has decreased (indicating less cash is tied up), add this amount.
Example:
Suppose a company has the following financials for a quarter:
Operating Cash Flow: $500,000
Capital Expenditures: $150,000
Change in Working Capital: Increase of $20,000 (indicating more cash is tied up in the business)
The NFCF calculation would be:
NFCF = $500,000 - $150,000 - $20,000 = $330,000
In this example, the company has $330,000 of net free cash flow available for the quarter.
By understanding and using this formula, business owners can get a clear picture of their true cash profitability and make more informed financial decisions.
Implementing the Net Free Cash-Flow Approach
Regular Monitoring: Track your NFCF on a monthly or quarterly basis. This allows you to identify trends, spot potential issues early, and make timely adjustments.
Cost Management: Review your expenses regularly to ensure they are necessary and efficient. Look for areas where you can reduce costs without compromising quality or growth.
Capital Expenditure Planning: Plan your capital expenditures carefully. While it's important to invest in growth and maintenance, these expenses should be justified and timed appropriately to avoid cash flow problems.
Efficient Working Capital Management: Optimize your inventory levels, manage receivables, and negotiate favorable terms with suppliers to maintain a healthy cash flow.
Reinvestment and Dividend Decisions: Use the insights from your Net Free Cash Flow to make informed decisions about reinvesting in your business or distributing profits. A healthy NFCF allows you to balance growth and owner’s earnings effectively.
The Benefits of the Net Free Cash-Flow Approach
Clarity and Simplicity: NFCF provides a straightforward measure of financial performance that is easy to understand and apply.
Enhanced Decision-Making: By focusing on actual cash available, business owners can make better decisions regarding investments, cost management, and profit distribution.
Improved Financial Health: Regularly monitoring and optimizing NFCF helps maintain a strong financial foundation, reducing the risk of liquidity issues and ensuring long-term sustainability.
Increased Investor Confidence: For businesses seeking investment, demonstrating strong and consistent Net Free Cash Flow can attract investors looking for solid, cash-generating opportunities.
Conclusion
Warren Buffett’s success is not just a result of “wise investments” but also a deep understanding of certain financial metrics like Net Free Cash-Flow. By adopting the Net Free Cash Flow approach, business owners can gain a clearer view of their company’s financial health, make more informed decisions, and ultimately increase their profitability and success.
Remember, success requires action—start measuring and optimizing your Net Free Cash Flow today to unlock the true potential of your business.
