What is Free Cash Flow? The Number That Actually Shows Whether a Business Can Make Payroll

Free cash flow represents the cash remaining after a business pays operating expenses and capital expenditures — the actual money available for growth, debt reduction, or reserves. Profitable companies sometimes miss payroll because cash and profit aren't the same thing, and free cash flow is an important indicator of financial health alongside other key metrics.

This guide covers what free cash flow measures, how to calculate it, and practical improvement strategies.

What is free cash flow?

Free cash flow (FCF) is the cash a company has left after spending money to support and maintain its operations and capital assets. This metric shows the actual cash generated by a business that's available for distribution or reinvestment after accounting for the capital expenditures needed to maintain or expand the asset base.

The fundamental formula is straightforward:

Free Cash Flow = Operating Cash Flow - Capital Expenditures

Operating cash flow represents the cash generated during normal business operations, while capital expenditures include purchases of equipment, technology, facilities, or other long-term assets. FCF shows the money that's left over after a business pays its operating expenses (such as mortgage or rent, payroll, property taxes and inventory costs) and capital expenditures.

Free cash flow differs critically from net income because it reflects actual cash movements rather than accounting profits. FCF and net income don't always equal out since businesses usually have a time gap between when they document a sale and when a customer pays the invoice. A business can show $100,000 in monthly profit on the income statement but can't make payroll because customers haven't paid their invoices yet.

FCF accounts for this timing difference by tracking when cash actually enters and leaves accounts. This makes it the most reliable indicator of whether core operations can sustain themselves, fund growth, or weather unexpected problems.

Why does free cash flow matter for business operations?

We've learned that understanding FCF provides several concrete advantages that directly affect the ability to run and grow a company. The following benefits shape how we make strategic decisions and maintain competitive positioning:

• Real-time financial health assessment: FCF tells you whether core business activities generate sufficient cash to sustain operations without external financing. According to Cube Software, this metric is "more than just a number on your financial statements — it's the lifeline of your business, especially for mid-sized companies looking to grow."
• Strategic decision-making capability: When you're considering whether to add 10 employees or open a new location, FCF shows whether there's financial capacity to execute without straining operations. You can then evaluate hiring decisions, expansion timing, and capital investments based on actual cash availability rather than projections or accounting estimates.
• Competitive advantage through liquidity: The National Center for the Middle Market emphasizes that "the greater a company's free cash flow, the better able it is to compete, invest, grow, and attract potential investors." Cash reserves create flexibility that competitors without strong FCF can't match.
• Early warning system for problems: Declining FCF despite stable revenue can signal working capital issues — such as stretched receivables, excess inventory, or accelerated payments — that require immediate investigation. However, declining FCF during planned growth investments may be intentional. The key is understanding the cause: review Days Sales Outstanding, Days Inventory Outstanding, Days Payable Outstanding, and capital expenditure timing to diagnose whether the decline reflects operational problems or strategic investments.

These benefits compound when you develop systematic approaches to tracking and improving FCF performance. The first step is knowing how to calculate the number itself, which is simpler than most finance metrics.

How do you calculate free cash flow?

Calculating FCF requires two numbers from the Cash Flow Statement, both readily accessible through the reports section of accounting software like QuickBooks, Xero, or NetSuite: Operating Cash Flow and Capital Expenditures. The mechanics are straightforward once you know where to look.

Step 1: Locate your operating cash flow

Open your Cash Flow Statement and find the section labeled "Cash Flows from Operating Activities." The bottom line of this section shows "Net Cash Provided by (Used in) Operating Activities." This is your operating cash flow figure, which represents actual cash generated by daily business operations.

Step 2: Identify your capital expenditures

Capital expenditures appear in the "Cash Flows from Investing Activities" section of the same Cash Flow Statement. Look for line items labeled "Purchase of Property, Plant & Equipment," "Purchase of Equipment," or "Capital Expenditures."

These amounts typically display as negative numbers since they represent cash outflows.

Step 3: Calculate your free cash flow

Subtract capital expenditures from operating cash flow to calculate FCF. For example, if your operating cash flow is $150,000 and capital expenditures total $30,000, your free cash flow is $120,000. According to Bill.com, this positive result indicates "they have some cash left over after taking care of their bills and maintaining the equipment that supports operations."

Step 4: Interpret the result

Positive FCF means the business is generating more cash than it's consuming, which creates capacity for growth or reserves. Negative FCF despite positive net income signals that profits are tied up in growth investments or working capital, which is normal for expanding businesses but unsustainable long term.

Consistently negative FCF without planned growth investments indicates structural problems requiring immediate attention.

What are the most common free cash flow challenges?

Several operational issues strain FCF even when revenue and profit appear healthy:

• Timing gaps between revenue and collections: A company delivers a $50,000 project in November and records the revenue immediately, but the client doesn't pay until February. Revenue is a great story. Payroll requires actual money. This represents one of the most common challenges in business. Revenue is a great story, but payroll requires actual money.
• Working capital inefficiency: Poor management of receivables, inventory, and payables creates structural cash drains. Deloitte's research shows that small companies generate an average of just 1.8% free cash flow as a percentage of revenue, compared to 6.8% for large companies, a nearly 4x performance gap driven primarily by working capital efficiency.
• Growth-driven cash consumption: Rapid expansion requires hiring ahead of revenue, purchasing inventory for larger orders, and extending credit to new customers. Each of these activities consumes cash before generating returns, which creates negative FCF during growth phases even when the underlying business is healthy.
• Capital investment timing: Major equipment purchases hit FCF immediately but are expensed gradually through depreciation. A $200,000 equipment purchase impacts FCF instantly but only affects net income by approximately $20,000 per year if depreciated over 10 years.

Recognizing these patterns helps identify where specific improvements will have the most impact.

What are the best practices for improving free cash flow?

Professional finance organizations recommend several proven strategies for strengthening FCF performance. These tactics provide measurable improvements when applied systematically.

Implement 13-week rolling forecasts

According to Deloitte, "a robust 13-week cash-flow forecast will assist in your communication with the banks and other key stakeholders as it better monitors debt covenants." Update this forecast weekly to maintain visibility 8–10 weeks ahead. This will give you plenty of time to address potential shortfalls.

Improve the cash conversion cycle

Track three critical metrics that determine how quickly you convert operations into cash:

1. Days Sales Outstanding (DSO) measures how long it takes to collect payment from customers
2. Days Inventory Outstanding (DIO) tracks how long inventory sits before being sold
3. Days Payable Outstanding (DPO) shows how long your business takes to pay suppliers

The formula Cash Conversion Cycle = DIO + DSO - DPO reveals how many days cash is tied up in operations. Reducing the cash conversion cycle through faster collections and strategic payment timing directly improves your cash position.

Structure payment terms strategically

Offer 1–2% discounts for payment within 10 days to accelerate collections without significantly impacting margins. In a time when cash flow can make or break a business, this simple change can compress your cash conversion cycle by weeks.

Maintain strategic cash reserves

Calculate your monthly burn rate and multiply by three to establish a minimum reserve target. Three months of runway feels comfortable. Six months lets you sleep through the night.

Automate expense tracking and approval workflows

Manual processes create delays and blind spots that strain cash visibility. According to research from McKinsey, organizations can achieve up to 20% improvement in cash flow through systematic working capital improvements, including process automation and performance management for collections.

How to get started with free cash flow management

We've found that implementing effective FCF management doesn't require sophisticated systems or large finance teams. If you're still in founder-does-everything mode or running a company with 50–150 employees, start with practical steps that provide immediate visibility and control.

1. Establish baseline metrics

Pull your Cash Flow Statement for the past three months and calculate FCF for each period. Compare your FCF as a percentage of revenue against the small business average of 1.8%. If you're below this, you've identified your first priority.

2. Build a basic forecasting system

Create a spreadsheet tracking expected cash inflows and outflows for the next 13 weeks. List known commitments (payroll, rent, loan payments) and expected collections based on your accounts receivable aging report. Update this weekly.

3. Implement weekly cash reviews

Schedule 30 minutes every Monday to review your actual cash position against the forecast, update projections for the coming weeks, and identify upcoming gaps requiring action.

According to Harvard Business Review, a healthcare company using basic AI-supported supply chain and inventory management tools, combined with a 13-week rolling cash flow analysis, improved forecasting accuracy to almost 90% within a month while discovering "large amounts of idle cash."

4. Focus on working capital quick wins

Start with receivables management since collections directly improve free cash flow without requiring capital investment. Review your accounts receivable aging report weekly, contact customers with invoices older than 30 days, and establish systematic follow-up procedures for past-due accounts.

5. Establish credit facilities before crisis

Don't wait until you're facing cash shortfalls to arrange credit lines. Banks prefer lending to companies with strong cash positions rather than those facing immediate liquidity problems, so establish relationships and facilities when you don't urgently need them.

FAQs about free cash flow

What's the difference between free cash flow and profit?

Profit represents accounting performance after all expenses are deducted, including non-cash items like depreciation. Free cash flow shows actual spendable cash after operating expenses and capital investments. A business can be profitable on paper while having negative FCF due to timing gaps between when transactions are recorded and when cash actually changes hands. Put simply: profit is what accountants celebrate. Free cash flow is what keeps the lights on.

How much free cash flow should a healthy business generate?

General healthy ranges target 10–15% FCF margin (FCF as a percentage of revenue), though industry variations exist. According to Deloitte's research, large companies average 6.8% while small companies average just 1.8%. This creates a significant performance gap that represents the primary improvement opportunity for smaller firms.

For SaaS companies specifically, revenue growth rate plus FCF margin should typically equal at least 40% (according to the Rule of 40 benchmark widely used by investors).

Is negative free cash flow always bad?

Negative FCF isn't inherently problematic if it results from planned growth investments that will generate future returns. A company expanding into new markets, purchasing equipment for capacity increases, or building inventory for a major contract might show temporary negative FCF.

However, consistently negative FCF without strategic growth investments signals operational problems requiring immediate attention.

What tools do I need to track free cash flow effectively?

Start with your existing accounting software since QuickBooks and some similar platforms can generate Cash Flow Statements automatically, while Xero may require additional setup, custom reporting, or integrations. These native capabilities suffice for basic tracking and forecasting.

Consider adding dedicated cash flow forecasting tools like Float or Cube when you need advanced scenario planning, more detailed visualization, or deeper analysis of business variables affecting your finances.