For businesses of all sizes, keeping a close eye on cash flow is an important part of safeguarding your company’s financial health. There are many ways that you can measure cash flow. At the simplest level, simply comparing your business’s bank account balance with the balance from one month ago will provide a basic cash flow measurement. But there are more sophisticated ways to conduct cash flow analysis, namely: operating cash flow and free cash flow. But what are the differences between these two metrics? Learn more about operating cash flow vs. free cash flow with our comprehensive guide.
What is operating cash flow?
Operating cash flow – also called cash flow from operating activities or cash flow provided by operations – refers to the capital that your business generates through its core business activities. It doesn’t include expenses, revenue drawn from investments, or long-term capital expenditures. In other words, the operating cash flow ratio is entirely focused on your normal business operations.
Operating cash flow is a crucial metric to understand because it tells you whether your business has enough funds to run the company and grow operations. Businesses with a positive operating cash flow, for example, can launch initiatives to fund growth, develop new products and service lines, and pay dividends to shareholders. That wouldn’t be possible with a negative operating cash flow ratio.
How to do an operating cash flow calculation
The formula that businesses use to do an operating cash flow calculation is likely to vary, as different businesses won’t always have the same items on their balance sheet. Generally speaking, however, you can calculate the operating cash flow ratio with the following formula:
Operating Cash Flow = Net Income + Non-Cash Items + Changes in Working Capital
What is free cash flow?
Free cash flow refers to the money that your business generates from its core business activities, after subtracting capital expenditures (i.e. long-term fixed assets like equipment or real estate). In other words, you can think of free cash flow as the amount of cash that your business has left over after accounting for cash outflows that help to expand your assets and support ongoing operations.
Free cash flow is a useful tool for working out not only how effectively your business is able to generate cash from normal business activities, but also how significantly your cash flow is impacted by capital expenditures. Investors and business analysts will often look at free cash flow to work out whether your company has enough money to repay creditors, buyback shares, and issue dividends.
How to calculate free cash flow
Learning how to calculate free cash flow is a relatively simple process, as you simply need to do an operating cash flow calculation and subtract the cost of long-term capital expenditures. This formula can be expressed in the following way:
Free Cash Flow = Operating Cash Flow – Capital Expenditures
Is operating cash flow the same as free cash flow?
Now that you know a little more about these financial performance metrics, let’s look at operating cash flow vs. free cash flow. Essentially, the key point of difference between the two metrics is the fact that free cash flow and operating cash flow are a measure of different things. Whereas operating cash flow ratio is solely concerned with the amount of cash generated by your business’s core operating activities, free cash flow looks at how effectively cash from those core operations is generated.
For example, an operating cash flow calculation may indicate that your business has a stockpile of capital from core business activities. However, when you look at the company’s free cash flow, cash outlays may reveal that the business has actually taken on a considerable level of debt, and as such, isn’t in such a strong financial position. When taken together, both metrics should give you a comprehensive understanding of your company’s financial health.
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On the contrary, Free cash flow, as the name suggests, is the cash available to the business enterprise. There are many who do not understand the terms clearly and end up juxtaposing the two. so, take a read of the given article to understand the difference between cash flow and free cash flow.
Content: Cash Flow and Free Cash Flow
- Comparison Chart
- Definition
- Key Differences
- Conclusion
Comparison Chart
| Meaning | Movement of cash of an organization, resulting in either increase or decrease of its cash is known as cash flow. | Cash available with the organization to be distributed among security holders is known as free cash flow. |
| Calculation | The sum total of Operating, Investing and Financing cash flows. | Operating Cash flows less Capital Expenditure. |
| Advantage | Helpful in determining the liquidity of the company. | Helpful in determining a company's financial health. |
Definition of Cash Flow
The incoming and outgoing of cash in a particular financial year results in the increase or decrease in the cash position of the company is known as cash flow. It arises due to the activities of the business, i.e. operating, investing and financing activities. In a nutshell, the difference between cash at the beginning and the end of the financial year is regarded as cash flow for the respective year.
Here, operating activities amount to the day to day business activities like sales or purchases of merchandise, payment to creditors, suppliers or employees, receipts from debtors, etc. Investing activities account for the sale or purchase of an investment or an asset. Financing activities amount to the issue or redemption of shares or debentures, payment of dividend, etc.
Definition of Free Cash Flow
The actual cash available with the company, for distribution it to its security holders, is known as free cash flow. A positive free cash flow reveals that the company is generating enough cash to run the enterprise efficiently. However, the Negative free cash flow shows that the company is not able to generate sufficient cash, or it has invested money somewhere else which will generate high returns in the future.
There are several methods for the calculation of company’s free cash flow, but one popular method is given as under:
Here,
- FCF = Free Cash Flow
- EBIT = Earnings Before Interest and Taxes
- WC Changes = Working Capital Changes
- Capex = Capital Expenditure.
the following points discuss the difference between cash flow and free cash flow in detail:
- The inflow and outflow of cash during a particular financial year is known as cash flow. The cash left with the company to be apportioned among the shareholders is known as free cash flow.
- Cash Flow discloses the solvency of the company whereas Free Cash Flow discloses the performance of the company.
- Cash flow is calculated by the summation of operating, investing and financing activities. Free Cash Flow uses only cash from operating activities for its calculation.
Conclusion
Therefore, you might have understood, the meaning and difference between cash flow and free cash flow. The disclosure of both cash flow and free cash flow is important in the company’s financial statement because the investment and financing decision is based on these two factors.