Understanding free cash flow

Cash flow is one of the most important things to get right in a small business. But there are different types of cash flow, and free cash flow is one of the most useful metrics to understand for your business, both for your own decision-making when it comes to conversations with lenders or investors.

Here's what free cash flow actually means, how to calculate it and why it matters.

What is free cash flow?

Free cash flow (FCF) is the cash your business generates after accounting for the money spent maintaining or expanding its assets. It's what's left over once the bills for running and investing in the business have been paid.

Unlike profit, which is an accounting figure, free cash flow reflects money that's actually available, whether that’s to pay down debt, reinvest in growth, return to shareholders or keep as a buffer for quieter periods. It's one of the most honest indicators of the financial health of your business.

Free cash flow formula

The standard free cash flow formula is:

Free cash flow = Operating cash flow − Capital expenditure

Operating cash flow is the cash generated by your core business activities - sales income minus day-to-day operating costs. Capital expenditure (capex) is the money you've spent on buying or maintaining physical assets like equipment, vehicles or property.

Subtract one from the other and you get your free cash flow.

How to calculate free cash flow

The numbers you need can be found in your cash flow statement. If you're not already producing one regularly, it's worth getting into that habit as it's one of the most useful financial documents a small business can maintain.

Here's a simple example. If your business generated £120,000 in operating cash flow last year and spent £30,000 on new equipment, your free cash flow would be:

£120,000 − £30,000 = £90,000

That £90,000 is the cash genuinely available to the business after operations and investment have been covered.

If your capex was higher - say you'd invested £100,000 in new machinery - free cash flow would be just £20,000, even though operating cash flow was the same. That doesn't necessarily mean anything's gone wrong; it just reflects the investment you've made.

Why does free cash flow matter for businesses?

Free cash flow tells you something profit alone can't. A business can be profitable on paper and still face serious cash flow problems if money is tied up in unpaid invoices, heavy stock levels or major asset purchases.

Tracking free cash flow helps you understand your real financial position - how much cash is genuinely available, not just what the accounts suggest. It makes it easier to judge whether you can expand, hire new staff or invest in equipment using the money in your business. 

Lenders often look at free cash flow when assessing loan applications, so it can help with that too. And it helps you spot problems early; an ongoing decline in FCF is worth investigating, even when turnover looks healthy.

For more on managing your cash flow day to day, take a look at our guides on how to manage your cash flow and short-term cash flow tips. 

FAQs

Unlevered vs levered free cash flow

Unlevered free cash flow (also called free cash flow to the firm) is calculated before the effect of debt  so it ignores interest payments. It reflects the cash available to all capital providers, both debt and equity holders.

Levered free cash flow accounts for debt obligations, showing what's left after interest and loan repayments. For most small business owners, levered free cash flow reflects what you actually have available once your financing costs are covered.

Free cash flow vs operating cash flow

Operating cash flow shows how much cash your core business activities are generating. Free cash flow takes that further by subtracting capital expenditure, so it's a more complete picture of what's genuinely available after investing in the business.

If the gap between operating cash flow and free cash flow is consistently large, it means a significant portion of your earnings are being reinvested in assets. That's not necessarily a problem, it depends on the nature of your business and whether those investments are generating a return.

What to use free cash flow for

Free cash flow is there to be used, not left sitting in the business without a purpose. Most businesses put it towards reinvesting in growth, whether that’s hiring, developing new products or expanding operations, while others use it to pay down debt and strengthen their financial position.  In more established companies, it might also be returned to shareholders.

What you do with it depends on where your business is right now.

Even with healthy free cash flow, timing gaps can still arise when expenses come before income. If an investment is going to drain your free cash flow, consider alternatives to paying upfront. With FlexiPay, you can spread the cost of large invoices or equipment purchases over 1-12 months. This means you can invest in growth without seeing your free cash flow drop to zero.

07/05/26: While we want to help as much as we can, the information found here is provided solely for informational purposes and should not be considered financial or legal advice. To the extent permitted by law, Funding Circle does not accept any liability for any loss or damage which may arise directly or indirectly from the use of, or reliance on, the information contained here. If you have any questions, please speak to your professional adviser or seek independent legal advice.