This is a complete guide on how to calculate Free Cash Flow to Sales Ratio with in-depth analysis, interpretation and example. You will learn how to use its formula to evaluate a business efficiency.
Definition - What is Free Cash Flow to Sales Ratio?
The free cash flow to sales ratio is used to measure the “real” amount of cash that a company has earned over a given period.
Any ratio using the actual cash a company has tends to be more reliable because it’s much harder for a company to manipulate that figure.
In this case, you get a more realistic picture of exactly how much the company’s sales are bringing in.
More...
Formula
To calculate this ratio, you simply need to divide the Company’s total in free cash flow by its total revenue from sales for that same period. The formula looks like this:
Free Cash Flow to Sales = Free Cash Flow / Sales Revenue
Both free cash flow and sales revenue can be found on the company’s financial statements.
Example
Company B has reported $2,000,000 in sales revenue for the quarter. At the same time, the company’s statements show $175,000 in free cash flow.
To find the FCF to sales ratio of this company, then, our equation will look like this:
This means the company has a free cash flow to sales ratio of 6.25%
This means the company has a free cash flow to sales ratio of 6.25%
Interpretation & Analysis
In general, you want to look for a company with a ratio above 5%.
This shows that the company is generating enough extra to cash to continue achieving growth.
According to that, standard, then, Company B has an impressive FCF/Sales ratio.
This is good to see because a company can show impressive sales revenue and use that number to impress shareholders.
However, if all of that revenue is eaten up by capital expenditures and just keeping the company just barely running with no room for growth, you don’t have much to look forward to.
Free cash flow is the amount of money the company has leftover after spending what it needs to spend to keep operating.
This is the money the company uses to pay off debt, pay out dividends, or reinvest in growing the company.
So the more free cash it is generating, the better.
Cautions & Further Explanation
While cash based ratios are generally more reliable, it’s important to remember that a company’s total free cash flow can still be manipulated to some degree.
For example, they might be including payments the company has made but that still haven’t been processed as “cash on hand” even though it’s actually been spent already.
They might also manipulate the number by including cash expected to come in the following quarter in the current quarter.
Combining that with the decision not to report cash expected to go out can lead to some serious overinflation of the company’s actual free cash flow. So you still need to be careful.
You also need to remember that the FCF to sales revenue ratio is not the only measure of a company’s health.
On its own, this ratio should be used as little more than a signal to look deeper into the company’s financials.
If everything else looks good as well, then this is a strong company.
If you’re trying to figure out how healthy a company is, you’ll also want to look at some other measures along with the free cash flow to sales ratio.
Other measures you’ll look at might include profit margin, earnings per share, net worth, and total equity.
