Debt Free Cash Flow
Debt free cash flow tells us how much cash is coming in that isn’t being used to pay off debt; it’s simply an adjustment to give a more accurate picture of cash flow. This metric helps us figure out how close to, or how deep in, negative leverage (when the cost of borrowing money is more than the return) we are. It sounds counter-intuitive but using cash flow to pay off debt can be more expensive than using that cash to, say, grow the business. A debt free cash flow calculation can help guide smarter debt management decisions and avoid knee-jerk reactions to interest rate fluctuations.
Debt Free Cash Flow in depth
Debt free cash flow before financing takes the cash flow before financing (called CFBF below, it’s the cash flow any changes in debt, distributions, owner equity, or financing) and adjusts it by eliminating any interest expense after adjusting for taxes. This adjustment shows the business owner how much cash flow before financing is being used up by the interest expense on the financed debt of the company.
Typically, a business owner thinks that debt free cash flow just eliminates debt payments – in particular, the principal payments. The issue here is that cash flow before financing does not include the effect of debt financing but it does include the effect of interest expense. So what is being eliminated specifically in debt free cash flow before financing is the interest expense on financed debt. This interest expense can be a significant number even if the company is not yet close to negative leverage.
Reducing interest expense means that for every dollar of interest expense reduced it will take about $21 after tax to achieve this. How is this possible?
Let’s say that we have $10,000 of annual interest expense on $167,000 of interest bearing debt implying an annual interest rate of 6%. Now let’s assume management wants to reduce the annual interest expense by $3,000. Take the $3,000 and divide it by 6% resulting in an amount of $50,000. That $50,000 has to be paid off with after tax dollars so assuming a tax rate of 25% average means that the business needs to earn $62,500 to pay off $50,000. Dividing the $62,500 by $3,000 means that we need to pay $20.83 for every dollar of interest expense reduced.
That is why many times it is more effective and less costly to grow the firm relative to over-all debt financing rather than consciously paying it down in the short term. Paying down debt eats up cash flow. In the example above you would one time eat up $20.83 in short term cash flow to achieve a an after tax $0.75 in on-going cash flow for a return on investment of less than 4% annually. If the company’s return on assets (ROA) is higher than 4% this would not be a good idea.
Another thing that can affect CFBF is a change in the interest rate on the financed debt without any change in the debt balances. Management wants to see that it is accomplishing its CFBF goal and can be misguided by changes in the overall interest rates that are not in their control. By observing the CFBF and the debt free CFBF, management can effectively make decisions around the level of debt balances or even if it is appropriate to refinance the debt or to change the ratio of term debt to short term or line of credit debt.
Debt Free Cash Flow example
Most people have a fairly varied debt portfolio. You might have a car payment, left-over student loans, a credit card or two – a veritable rainbow of borrowed money. If you do all the math to figure out how much each year you’re paying in interest, you might scare yourself with a number like $1,200. Do some more math, though, and you might figure out that you need $12,000 in income (after tax, of course) to knock that down by half. Is $600 saved worth more than $12,000 in cash flow? You better be sure before you send that check!
Paying off debt is important but not at the cost of potential growth. Falling into the debt payment trap could mean serious lost returns. Let us help you aptly manage your business’s cash flow and determine where your cash will help the most.