Free Cash Flow to Sales Ratio

Free cash flow-to-sales is a performance ratio that looks into a company’s operating cash flows after subtracting all sales-relative capital expenditures. It is a crucial measurement in assessing a company’s fiscal status and knowing its intrinsic valuation. Free cash flow-to-sales is monitored over time. You can compare it with the ratios of other companies in the same industry to better understand the implications.

Free cash flow is crucial to the company and its shareholders. This is due to the fact that this money can be used to distribute bigger dividends, bring down shares outstanding by buying back shares (hence increasing earnings per share, all else equal), or secure acquisitions to boost the company’s growth prospects. How a company manages free cash flow is included in its policy for capital distribution.

Obviously, having more free cash flow is favorable. But how much, exactly, this should amount to? The result must be placed in context in order to make the free cash flow-to-sales ratio meaningful. Generally, a ratio higher than five percent is preferable.

Essentially, this indicates a company’s robust ability to pull in enough cash to keep growing. This will also serve the company well when trying to please shareholders. But if such revenue all goes to capital expenditures and leaves the company with almost no opportunities for growth, then there isn’t much to celebrate.

Keep in mind that free cash flows-to-sales have to be monitored over adequate long-term periods. This can cover short-term periods when a company is investing aggressively as part of its growth agenda. Thus, low or negative free cash flow sales don’t always indicate problems. Rather, it could mean that the business is making heavy capital investments, preparing for an anticipated increase in future demand. The ratio may be low for one or two years, but it is expected to go up and stabilize.

Free Cash Flow To Sales Formula

FCF\: to\: Sales = \dfrac{Free\: Cash\: Flow}{Sales\: Revenue}

This formula refers to the difference between a company’s operating cash flow and capital expenditures. All figures needed for this calculation can be found on the financial statements of the company.

While there could be minor differences in how companies compute their free cash flows, the free cash flow-to-sales ratio is often obtained by subtracting a business’ capital expenditures from its operating cash flows. Capital expenditures are needed every year to, at least, keep an asset base and establish a foundation for expansion in the future. When operating cash flow surpasses this kind of reinvestment, free cash flow is made.

Free Cash Flow To Sales Example

For the fiscal year 2019, ABC Company made a total of $200.2 billion in sales. Its operating cash flow came in at $68.1 billion while its capital expenditures amounted to $5.8 billion. What is ABC Company’s free cash flow-to-sales ratio?

Let’s break it down to identify the meaning and value of the different variables in this problem. 

  • Free cash flow-to-sales: unknown
  • Free cash flow: 68,100,000 – 5,800,000 = 62,300,000
  • Sales revenue: 200,200,000

Now let’s use our formula and apply the values to our variables to calculate free cash flow-to-sales:

FCF\: to\: Sales = \dfrac{62{,}300}{200{,}200} = 31.12\%

In this case, ABC Company would have a free cash flow-to-sales ratio of 31.12% for 2019.  Clearly, the company is enjoying a very high free cash flow-to-sales ratio. This means it has a superb ability to convert its sales into cash.

In more practical terms, it shows that the company is putting a generous amount of extra cash towards growth. But like other metrics, the free cash flow-to-sales ratio shouldn’t be reviewed alone but rather side by side with other ratios that speak of a company’s financial health. It should also be studied within a specific period instead of just a single fiscal year. This can help you to spot trends and gain more insights. 

Free Cash Flow To Sales Analysis 

Free cash flow is technically money the company is left with after paying all its operating costs. This is what the company uses to cover its debt, distribute dividends, or reinvest into the company’s growth. Hence, the more free cash, the better. The higher the free cash flow-to-sales ratio, the more capable a company is of converting its sales into what counts the most: cash.

Keeping track of trends and comparing ratios of peers also offers hints about the company’s market competitiveness.

If, say, a company sees that free cash flow has has been going down, it should study the components of operating cash flow and review capital expenditures to get a higher ratio. If the company observes an increase while the ratio is hardly within the industry’s range, management should explore different avenues to bridge the gap.

Also, while cash-based ratios are usually more accurate, it’s a must to note that a business’ total free cash flow can be easily manipulated to a certain extent. 

For instance, it could be tweaked to include payments made by the company which are not yet considered as cash on hand despite being spent already, or cash that is yet to come in the next quarter. 

When this is done simultaneously while not reporting cash outflows, the company’s free cash flow figure can end up severely over-inflated. It’s also important to note that the free cash flow-to-sales ratio is not the sole metric for assessing a financial health. Alone, this ratio shouldn’t be used as more than an indicator of the need to investigate further into a business’ financial position. 

In other words, when seeking the sharpest picture of a company’s fiscal health, it is crucial to check other measures aside from the free cash flow-to-sales ratio. This should include profit margin, total equity, net worth and earnings per share.

Free Cash Flow To Sales Conclusion

  • The free cash flow-to-sales ratio measures how much cash a company is making after its capital expenditures.
  • This formula requires two variables: free cash flow and sales revenue.
  • The free cash flow-to-sales ratio is usually expressed as a percentage.
  • The free cash flow-to-sales ratio should be studied over a period of time or against competition to get a more accurate view of the company’s efficiency.
  • A higher result indicates a greater capability to convert sales into cash.

Free Cash Flow To Sales Calculator

You can use the free cash flow-to-sales calculator below to quickly calculate how much money a company makes after paying its capital costs, by entering the required numbers.