Free Cash Flow vs. Operating Cash Flow: An Overview
Free cash flow is the cash that a company generates from its normal business operations after subtracting operating expenses, before interest payments, and after subtracting any money spent on capital expenditures. Capital expenditures, or CAPEX for short, are purchases, upgrades, or maintenance of capital assets, such as property, factories, and equipment.
Operating cash flow, on the other hand, is the cash that’s generated from normal business operations or activities. Operating cash flow shows whether a company generates enough positive cash flow to run its business and grow its operations.
Free cash flow and operating cash flow are often used as metrics when comparing competitors in the same or comparable industries. Operating cash flow, free cash flow, and earnings are all important metrics when researching and evaluating a company that is being considered for investment.
Key Takeaways
- Operating cash flow measures cash generated by a company’s business operations.
- Free cash flow is the cash that a company generates from its business operations after subtracting capital expenditures.
- Operating cash flow tells investors whether a company has enough cash flow to pay its bills and turn a profit.
- Free cash flow tells investors and creditors that there’s enough cash remaining to pay back creditors, pay dividends, and buy back shares.
Operating Cash Flow
Operating cash flow is an important metric because it shows investors whether or not a company has enough funds coming in to pay its bills, taxes, or operating expenses. In other words, there must be more operating cash inflows than cash outflows for a company to be financially viable in the long term.
Operating cash flow is calculated by taking revenue and subtracting operating expenses for the period. Operating cash flow is recorded on a company’s cash flow statement, which is reported both on a quarterly and annual basis. Operating cash flow indicates whether a company can generate enough cash flow to maintain and expand operations, but it can also indicate when a company may need external financing for capital expansion.
Free Cash Flow
Free cash flow represents the cash flow that is available to all investors before cash is paid out to make debt payments, dividends, or share repurchases.
Free cash flow is typically calculated as a company’s operating cash flow before interest payments and after subtracting any capital purchases. Capital expenditures are funds a company uses to buy, upgrade, and maintain physical assets, including property, buildings, or equipment.
In other words, free cash flow helps investors determine how well a company generates cash from operations but also how much cash is impacted by capital expenditures. Free cash flow can be envisioned as cash left after the financing of projects to maintain or expand the asset base.
Free cash flow is a measure of financial performance, similar to earnings, and its use is considered to be one of the non-Generally Accepted Accounting Principles (GAAP) financial metrics.
Free Cash Flow and Dividends
The amount of cash flow available is usually used to calculate how likely a company can make its dividend payments. Dividends are cash payments to investors as a reward for owning the stock. If a company is generating free cash flow that exceeds dividend payments, it’s likely to be seen as favorable to investors, and it could mean that the company has enough cash to increase the dividend in the future.
Investors use a company’s free cash flow to equity figure to determine how much cash is remaining to pay for dividends. Free cash flow to equity is a specific free cash flow measure that calculates the cash available to only equity investors. It is the cash available after the debt holders have been paid and after debt issues and repayments have been accounted for.
Many analysts feel dividend outlays are just as important an expense as capital expenditures. The board of directors of a company may elect to reduce a dividend payment. However, this usually has a negative effect on the stock price, as investors tend to sell holdings in companies that reduce dividends.
Free Cash Flow and Creditors
Free cash flow measures the cash flow available for distribution to all company securities holders, including creditors. Banks that lend to companies want the company to be able to generate free cash flow so that the company is able to pay back the debt.
If a company wanted to borrow an additional amount of money from their bank, the lender would use free cash flow to determine the amount of loan the company could repay. The lender would subtract the current debt payments from free cash flow to determine the amount of cash flow available to pay for additional borrowings.
Limitations of Free Cash Flow
However, there are limitations to free cash flow, including companies that have significant capital purchases. For example, some industries are very capital intensive, such as the oil and gas industry. Oil companies must purchase or invest a significant amount of capital in fixed assets, such as machinery and drilling equipment. As a result, free cash flow can be inconsistent over time since these significant capital outlays of cash are needed.
It’s important that investors compare free cash flow with similar companies or industries. It doesn’t make sense to compare the free cash flow of an oil company with the free cash flow of a marketing firm that has no significant capital purchases or fixed assets.
Important
Companies with positive free cash flow are able to expand their business while those with falling free cash flow might need restructuring or additional financing.
Free Cash Flow vs. Operating Cash Flow Examples
Below is the cash flow statement for Apple Inc. (AAPL) as reported in the company’s 10-Q filing for the period ending December 28, 2019.
Operating Cash Flow
At the top of the cash flow statement, we can see that Apple carried over $50.224 billion in cash from the balance sheet and $22.236 billion in net income or profit from the income statement. Once the day-to-day operating expenses are deducted, we arrive at the company’s operating cash flow.
Apple recorded $30.516 billion in operating cash flow (highlighted in green). The aggregate amount of operating cash flow included the daily operating activities, such as:
- Inventory purchases for $28 million
- Accounts receivables for $2.015 billion, which represents money owed to Apple by its customers for booked sales
- Accounts payables of $1.089 billion, which is money owed by Apple to its suppliers and vendors
Free Cash Flow
- Apple invested in a new plant and equipment, purchasing $2.107 billion in assets (in red). The purchase is a cash outlay.
- We already know that the company’s operating cash flow was $30.516 billion.
- As a result, Apple’s free cash flow was $28.409 billion for the period ($30.516 – $2.107).
- Since the interest figure is not given, this free cash flow is before adding back the interest payments.
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